In general, organisations can raise the capital they need to finance their business operations in two different ways: debt finance and equity finance.
This article will focus on debt financing although it will also examine some of the advantages and disadvantages of debt financing versus equity financing.
What is debt financing?
Debt financing is the process by which an organisation raises the finance it needs by borrowing money from an external third party. These external lenders can include commercial banks, investment banks or institutional investors.
All debt financing arrangements have the same characteristics: the amount borrowed must be repaid in full, within a specified timeframe, and interest (or a coupon) will be charged. Some debts will be secured against the assets of the company and others will remain unsecured.
In general, secured debt is cheaper and attracts lower rates of interest as the lender can rely on selling the security if the borrower is unable to repay the debt. Conversely, unsecured debt is more expensive as the lender bears the shortfall risk if the borrower fails to repay the debt in full.
Types of debt financing
There are many different types of debt finance: overdraft facilities, bank term loans, convertible loan notes, mini-bonds, corporate bonds, convertible bonds and asset-based lending such as leasing to purchase plant and equipment.
The type of debt finance chosen will depend on the ease with which the borrower can access the capital it needs. For example, mini-bonds could be used when an early-stage company wants to tap in to its loyal customer base to raise capital. Banks may be unwilling to lend to start-ups because there is a greater risk that unproven companies will repay the debt.
The borrowing decision will also depend on the cost of the debt. For example, a manufacturing company may decide that it makes more sense to purchase machinery through a leasing arrangement than a bank term loan as the lessor may also insure and maintain the equipment whereas a bank will not.
Sources of debt finance
There are a number of different sources of debt finance: banks, institutional investors, peer-to-peer lenders or specialists such as lease providers that facilitate the purchase of fixed assets needed to run the business.
Advantages of debt financing over equity financing:
- Using debt to fund a company’s operations avoids the need to issue shares (equity) to new investors, which would mean giving up a percentage of ownership in the business.
- The range of debt financing solutions available gives the borrower much more flexibility. For example, a company with a short-term cashflow problem can apply for a bank overdraft facility to manage their working capital needs instead of doing an equity fundraising.
- Issuing shares would not be appropriate to fund a temporary cashflow shortfall (although a number of cash-strapped AIM listed companies have been known to use equity as a working capital solution).
- Debt financing arrangements can be structured in a way to suit the borrower’s needs. For example, a property development company can agree terms which include an ‘interest roll-up’ option and a bullet repayment. This means that during the construction phase, the interest due and payable is added to the loan and the loan is only repaid once the development has been completed (and sold).
- Interest payable on loans (or coupons paid on bonds), is a tax-deductible expense which can be offset against trading profits. This allows the borrower to mitigate their tax liability. Dividends paid on shares do not enjoy the same tax advantage.
Disadvantages of debt financing
- Lenders usually expect some form of collateral before they will offer a loan, so early-stage companies are unlikely to benefit from debt financing.
- Debt financing may not be suitable for start-up companies anyway as capital is needed to fund the growth of the business not to pay interest on loans etc
- Even where collateral is available, lenders will still assess the risk profile of the organisation and charge higher rates and fees if there are wider concerns about the sector in which the business operates.
- Where a company takes on much debt, it is considered to be highly geared (or over- leveraged). Investors may express concern over the ability of the company to service its debts and accordingly sell down or short the shares. This could lead to a fall in its share price.
- Overdraft facilities are repayable on demand and should the lender request repayment, this can lead to significant cashflow difficulties for the borrower.
- If the borrower fails to hedge (or fix) the interest rate payable on the loan, and interest rates rise, then this will have an adverse impact on cashflow and profits.
- If a borrower fails to repay a secured debt, this means the lender can enforce the security held as collateral and either sell the asset or appoint a licensed insolvency practitioner to potentially close down the company.
Other types of finance
To learn about equity financing, please click here.
