How Debt Financing Works, Examples, Costs, Pros & Cons (2024)

What Is Debt Financing?

Debt financing occurs when a firm raises money for working capital or capital expenditures by selling debt instruments to individuals and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid. The other way to raise capital in debt markets is to issue shares of stock in a public offering; this is called equity financing.

Key Takeaways

  • Debt financing occurs when a company raises money by selling debt instruments to investors.
  • Debt financing is the opposite of equity financing, which entails issuing stock to raise money.
  • Debt financing occurs when a firm sells fixed income products, such as bonds, bills, or notes.
  • Unlike equity financing where the lenders receive stock, debt financing must be paid back.
  • Small and new companies, especially, rely on debt financing to buy resources that will facilitate growth.

How Debt Financing Works, Examples, Costs, Pros & Cons (1)

How Debt Financing Works

When a company needs money, there are three ways to obtain financing: sell equity, take on debt, or use some hybrid of the two. Equity represents an ownership stake in the company. It gives the shareholder a claim on future earnings, but it does not need to be paid back. If the company goes bankrupt, equity holders are the last in line to receive money.

A company can choose debt financing, which entails selling fixed income products, such as bonds, bills, or notes, to investors to obtain the capital needed to grow and expand its operations. When a company issues a bond, the investors that purchase the bond are lenders who are either retail or institutional investors that provide the company with debt financing. The amount of the investment loan—also known as the principal—must be paid back at some agreed date in the future. If the company goes bankrupt, lenders have a higher claim on any liquidated assets than shareholders.

Special Considerations

Cost of Debt

A firm's capital structure is made up of equity and debt. The cost of equity is the dividend payments to shareholders, and the cost of debt is the interest payment to bondholders. When a company issues debt, not only does it promise to repay the principal amount, it also promises to compensate its bondholders by making interest payments, known as coupon payments, to them annually. The interest rate paid on these debt instruments represents the cost of borrowing to the issuer.

The sum of the cost of equity financing and debt financing is a company's cost of capital. The cost of capital represents the minimum return that a company must earn on its capital to satisfy its shareholders, creditors, and other providers of capital. A company's investment decisions relating to new projects and operations should always generate returns greater than the cost of capital. If a company's returns on its capital expenditures are below its cost of capital, the firm is not generating positive earnings for its investors. In this case, the company may need to re-evaluate and re-balance its capital structure.

The formula for the cost of debt financing is:

KD = Interest Expense x (1 - Tax Rate)

where KD = cost of debt

Since the interest on the debt is tax-deductible in most cases, the interest expense is calculated on an after-tax basis to make it more comparable to the cost of equity as earnings on stocks are taxed.

Measuring Debt Financing

One metric used to measure and compare how much of a company's capital is being financed with debt financing is the debt-to-equity ratio (D/E). For example, if total debt is $2 billion, and total stockholders' equity is $10 billion, the D/E ratio is $2 billion / $10 billion = 1/5, or 20%. This means for every $1 of debt financing, there is $5 of equity. In general, a low D/E ratio is preferable to a high one, although certain industries have a higher tolerance for debt than others. Both debt and equity can be found on the balance sheet statement.

Creditors tend to look favorably on a low D/E ratio, which can increase the likelihood that a company can obtain funding in the future.

Debt Financing vs. Interest Rates

Some investors in debt are only interested in principal protection, while others want a return in the form of interest. The rate of interest is determined by market rates and the creditworthiness of the borrower. Higher rates of interest imply a greater chance of default and, therefore, carry a higher level of risk. Higher interest rates help to compensate the borrower for the increased risk. In addition to paying interest, debt financing often requires the borrower to adhere to certain rules regarding financial performance. These rules are referred to as covenants.

Debt financing can be difficult to obtain. However, for many companies, it provides funding at lower rates than equity financing, particularly in periods of historically low-interest rates. Another advantage to debt financing is that the interest on the debt is tax-deductible. Still, adding too much debt can increase the cost of capital, which reduces the present value of the company.

Debt Financing vs. Equity Financing

The main difference between debt and equity financing is that equity financing provides extra working capital with no repayment obligation. Debt financing must be repaid, but the company does not have to give up a portion of ownership in order to receive funds.

Most companies use a combination of debt andequity financing. Companies choose debt or equity financing, or both, depending on which type of funding is most easily accessible, the state of their cash flow, and the importance of maintaining ownership control. The D/E ratio shows how much financing is obtained through debt vs. equity. Creditors tend to look favorably on a relatively low D/E ratio, which benefits the company if it needs to access additional debt financing in the future.

Advantages and Disadvantages of Debt Financing

One advantage of debt financing is that it allows a business toleveragea small amount of money into a much larger sum, enabling more rapid growth than might otherwise be possible. Another advantage is that the payments on the debt are generally tax-deductible. Additionally, the company does not have to give up any ownership control, as is the case with equity financing. Because equity financing is a greater risk to the investor than debt financing is to the lender, debt financing is often less costly than equity financing.

The main disadvantage of debt financing is that interest must be paid to lenders, which means that the amount paid will exceed the amount borrowed. Payments on debt must be made regardless of business revenue, and this can be particularly risky for smaller or newer businesses that have yet to establish a secure cash flow.

Advantages of debt financing

  • Debt financing allows a business to leverage a small amount of capital to create growth

  • Debt payments are generally tax-deductible

  • A company retains all ownership control

  • Debt financing is often less costly than equity financing

Disadvantages of debt financing

  • Interest must be paid to lenders

  • Payments on debt must be made regardless of business revenue

  • Debt financing can be risky for businesses with inconsistent cash flow

Debt Financing FAQs

What Are Examples of Debt Financing?

Debt financing includes bank loans; loans from family and friends; government-backedloans, such as SBAloans; lines of credit; credit cards; mortgages; and equipmentloans.

What Are the Types of Debt Financing?

Debt financing can be in the form of installment loans, revolving loans, and cash flow loans.

Installment loans have set repayment terms and monthly payments. The loan amount is received as a lump sum payment upfront. These loans can be secured or unsecured.

Revolving loans provide access to an ongoing line of credit that a borrower can use, repay, and repeat. Credit cards are an example of revolving loans.

Cash flow loans provide a lump-sum payment from the lender. Payments on the loan are made as the borrower earns the revenue used to secure the loan. Merchant cash advancesand invoice financing are examples of cash flow loans.

Is Debt Financing a Loan?

Yes, loans are the most common forms of debt financing.

Is Debt Financing Good or Bad?

Debt financing can be both good and bad. If a company can use debt to stimulate growth, it is a good option. However, the company must be sure that it can meet its obligations regarding payments to creditors. A company should use the cost of capital to decide what type of financing it should choose.

The Bottom Line

Most companies will need some form of debt financing. Additional funds allow companies to invest in the resources they need in order to grow. Small and new businesses, especially, need access to capital to buy equipment, machinery, supplies, inventory, and real estate. The main concern with debt financing is that the borrower must be sure that they have sufficient cash flow to pay the principal and interest obligations tied to the loan.

How Debt Financing Works, Examples, Costs, Pros & Cons (2024)


What are the pros and cons of debt financing? ›

Pros of debt financing include immediate access to capital, interest payments may be tax-deductible, no dilution of ownership. Cons of debt financing include the obligation to repay with interest, potential for financial strain, risk of default.

What are the costs of debt financing? ›

The cost of debt is the effective interest rate that a company must pay on its long-term debt obligations, while also being the minimum required yield expected by lenders to compensate for the potential loss of capital when lending to a borrower.

How does debt financing work? ›

Debt financing occurs when a firm sells fixed income products, such as bonds, bills, or notes. Unlike equity financing where the lenders receive stock, debt financing must be paid back. Small and new companies, especially, rely on debt financing to buy resources that will facilitate growth.

Which of the following is an example of debt financing? ›

One example of debt financing is obtaining a bank loan, where a business borrows money from a bank and agrees to repay it over a specified period of time with interest. Another example is receiving money from an angel investor, where an individual provides funding in exchange for equity in the company.

What are the disadvantages of debt funds? ›

While debt funds are generally considered safer than equity funds, they are not entirely risk-free. Factors like interest rate risk, credit risk, and liquidity risk can affect the performance of debt funds.

What is the major advantage of debt financing? ›

#1 The major advantage of debt financing is the deductibility of interest expenses.

Why is debt financing cheaper? ›

Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders' expected returns are lower than those of equity investors (shareholders).

What are the two costs of debt finance? ›

There are two costs of debt finance. The explicit cost of debt is the rate of interest that bondholders demand. But there is also an implicit cost, because higher levels of debt increase the required rate of return to equity.

Why does debt have a cost? ›

The cost of debt, at its core, represents the effective interest rate a company effectively pays on its borrowings. Whether through bank business loans, bonds, or other financial instruments, this cost can impact a company's profitability and financial flexibility.

What are the agency costs of debt financing? ›

The agency cost of debt is the conflict that arises between shareholders and debtholders of a public company. Agency costs of debt arise when debtholders place limits on the use of their capital if they believe that management will take actions that favor shareholders instead of debtholders.

Is debt financing riskier? ›

Is Debt Financing or Equity Financing Riskier? It depends. Debt financing can be riskier if you are not profitable as there will be loan pressure from your lenders. However, equity financing can be risky if your investors expect you to turn a healthy profit, which they often do.

What are the two major forms of debt financing? ›

Debt Financing Options
  • Bank loan. A common form of debt financing is a bank loan. ...
  • Bond issues. Another form of debt financing is bond issues. ...
  • Family and credit card loans. Other means of debt financing include taking loans from family and friends and borrowing through a credit card.

What is the most common source of debt financing? ›

Loans From Financial Institutions

After all, of the many types of debt financing, traditional financial institutions are still one of the most common providers. To qualify, companies need to adhere to a strict set of requirements, boast robust credit history, and feature long-term investment history.

Which is a disadvantage of debt financing? ›

Drawbacks of debt financing

Having high interest rates – Interest rates vary based on various factors including your credit history and the type of loan you're trying to obtain.

When to use debt financing? ›

Debt financing is a sound financing option when interest rates are rising when you know can pay back both interest and principal. You don't even need to have positive cash flow, just enough cash available to pay for the interest on your debt and amortize the principal over the life of the loan.

How to structure debt financing? ›

Debt financing can be structured in the form of an installment loan, revolving loan or cash flow loan: Installment loan. You receive funding from a lender upfront and repay it, with interest, over a fixed payment schedule.

What are the advantages of debt financing? ›

Opting for debt financing can offer you a lower cost of capital, tax advantages through deductible interest payments, and the opportunity to maintain control and ownership of your business. It also allows you to benefit from leverage and retain stability in shareholder ownership.

Which type of debt fund is safest? ›

Overnight Fund is the safest among debt funds.

Why are debt funds risky? ›

Investing in debt funds carries various types of risk. These risks include Credit risk, Interest rate risk, Inflation risk, reinvestment risk etc. But the key risks which needs be considered before investing in Debt funds are Credit Risk and Interest Rate Risk; Credit Risk (Default Risk):

What are the advantages and disadvantages of short term debt financing? ›

The pros and cons of short-term debt
  • Pros and cons of short-term financing.
  • Pro: Relaxed eligibility. ...
  • Con: Higher interest rates. ...
  • Pro: Get approval in just hours or days. ...
  • Con: The high-cycle risk. ...
  • Pro: Quick payment plans no longer than 18 months. ...
  • Con: Could be habit-forming. ...
  • Pro: Less paperwork.
Jul 28, 2016

What are the advantages and disadvantages of a debt management plan? ›

Pros and Cons of Using a Debt Management Plan
  • You only need to make one monthly payment. ...
  • You may be able to secure lower interest rates. ...
  • You'll likely save a lot of money. ...
  • You Should See Your Credit Score Increase Over Time. ...
  • You are required to close your credit card accounts.

What are the positives and negatives of national debt? ›

The national debt enables the federal government to pay for important programs and services even if it does not have funds immediately available, often due to a decrease in revenue. Decreases in federal revenue coupled with increased government spending further increases the deficit.

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