What is debt financing and how does it work?

What is debt finance?

Debt financing is when a business raises the capital it needs to grow by borrowing money from a lender or a bank. In return for the loan, the lender charges interest on the amount borrowed and the debt is to be repaid at a later predetermined date.

Debt funding can include business loans, asset financing and invoice financing and can be a cost effective way to provide businesses with the necessary funds to develop and grow.

How does debt financing work?

The lender will release an agreed amount of money to the business but only once certain terms and conditions have been decided upon. These will include how the debt is to be repaid, interest rate to be added plus any penalties to be incurred should the repayments be late.

The lender will often need to know how the money is to be used and may assess the ability of the company to repay. This could include looking at debt and credit history, cash flow and quality of the product or service. Once all the terms have been agreed the money will be received by the business to invest in its future growth.

When a company takes on debt financing they retain control of their business.

What are the advantages and disadvantages of debt financing?

Advantages of debt finance

• Easily accessed for most businesses.
• Total ownership and control remains with the company.
• Different types of debt financing products make it easier to find one that fits best.
• Low interest rates can be achieved by extending the repayment time.
• Good credit history can be achieved by paying on time.
• Enables better planning and budgeting as the company knows exactly how much will be paid back and when.
• Repayments of the debt can be tax deductible.
• Can be cheaper than equity finance as there is less risk to a lender than to an investor.

Disadvantages of debt finance

• The debt must be paid back.
• Depending on the situation of the company debt financing may be expensive.
• Restrictions can be placed by the lender on how the money is used.
• Repayments may create cash flow problems at certain times of the year for some businesses.
• Lenders can require collateral in case of defaults putting assets at risk if repaying becomes a problem in the future.
• Limits may be placed on the amount you can borrow.