Debt Financing

Key takeaways

• Debt financing is raising capital by borrowing—typically through loans, bonds, or other fixed‑income instruments—that must be repaid with interest.
• It preserves ownership but creates mandatory repayment obligations and often includes covenants.
• Interest is usually tax‑deductible, which lowers the effective cost of borrowing; however, excessive debt increases risk and can limit flexibility.

What is debt financing?

Debt financing occurs when a company obtains funds by issuing debt instruments—such as loans, bonds, notes, or lines of credit—to lenders or investors. Lenders become creditors and receive contractual promises to receive periodic interest payments and return of principal at maturity. In bankruptcy, creditors have priority over equity holders for claims on assets.

How it works

Companies typically choose among three primary capital sources:
* Equity: issuing stock, which dilutes ownership but has no obligatory repayments.
Debt: borrowing funds that must be repaid with interest.
A hybrid: instruments such as convertible debt that can convert into equity.

When a business issues debt, it receives principal up front and agrees to pay coupon (interest) payments over time and return the principal at a specified maturity. Lenders assess credit risk and set interest rates accordingly; higher perceived default risk leads to higher rates.

Common types of debt financing

• Term loans — lump sum repaid over a set term with fixed or variable interest.
• Lines of credit — flexible borrowing up to a limit; interest paid only on amounts drawn.
• Revolving credit facilities — larger, repeatable draw/repay arrangements for substantial firms.
• Equipment financing — loans or leases secured by the equipment being purchased.
• Merchant cash advances — lump sum repaid via a share of future card receipts (often costly).
• Trade credit — short‑term supplier credit (payable in 30–60 days).
• Convertible debt — debt that can be converted into equity under agreed terms.
• Credit cards, mortgages, SBA and other government‑backed loans, invoice financing.

Cost of debt and measurement

The cost of debt reflects the interest a company pays, adjusted for the tax benefit of interest deductibility. A common expression is:

KD = interest rate × (1 − tax rate)

Because interest expense is typically tax‑deductible, the after‑tax cost of borrowing is lower than the nominal interest rate.

Capital structure is often assessed using the debt‑to‑equity ratio (D/E):
* D/E = Total Debt ÷ Shareholders’ Equity
Example: If total debt is $2 billion and equity is $10 billion, D/E = 0.2 (20%). Creditors generally prefer lower D/E ratios because they imply less leverage and lower default risk.

A company’s weighted average cost of capital (WACC) combines cost of debt and cost of equity and represents the minimum return needed on investments to satisfy both creditors and shareholders.

Debt financing vs. equity financing

• Debt: must be repaid with interest; ownership remains unchanged; interest is tax‑deductible; lenders impose covenants; carries default risk.
• Equity: no repayment obligation; dilutes ownership; shareholders expect returns (dividends or appreciation); generally costlier over the long term.

Most firms use a mix of debt and equity, balancing cost, control, cash‑flow capacity, and risk.

Advantages and disadvantages

Pros
* Retains ownership and control.
Interest is often tax‑deductible, lowering after‑tax cost.
Can be less expensive than equity over time.
* Fixed term—obligation ends when repaid.

Cons
* Mandatory interest and principal payments regardless of revenue.
Increases financial risk and may constrain cash flow.
Excessive debt can raise future borrowing costs and limit strategic flexibility.
* Lenders may impose restrictive covenants.

When to choose debt financing

Debt is often preferred when:
* The company can reliably service interest and principal from cash flows.
Management wants to preserve ownership and control.
Interest rates are favorable relative to the cost of equity.
* The company seeks to leverage capital to accelerate growth without diluting shareholders.

Avoid excessive debt when cash flows are uncertain or the business cannot meet predictable repayment schedules.

Examples

Typical debt financing sources include bank term loans, lines of credit, credit cards, equipment loans, mortgages, government‑backed loans (e.g., SBA), trade credit, and merchant cash advances.

Bottom line

Debt financing is a key tool for funding operations and growth. It offers tax and ownership advantages but creates fixed obligations and financial risk. The right balance between debt and equity depends on a company’s cash‑flow stability, growth needs, cost of capital, and tolerance for leverage.