Debt Financing

What is Debt Financing?

Debt financing involves firms raising capital to fund their operations and growth. Companies can use this capital to purchase PP&E, fund an acquisition or settle a legal dispute. Debt is an amount of money borrowed from one party on the condition that the amount borrowed (principal) is repaid later. Along with the principal, the lenders expect to be compensated through interest payments. There are many different debt products available depending on the financial interests of the company. These can be categorized into non-current and current.

Understanding Debt financing

Businesses require a source of financing to fund both their short-term (working capital) and long-term (capital expenditures) needs. There are two ways of raising funds: 1) Equity financing and 2) Debt financing.

Equity financing is raising funds by selling equity or an ownership stake in the business. The business is not obligated to provide any returns to equity holders. Their returns are linked to the performance of the business. If the business does good, they profit from share price appreciation and may also get a share in profits as dividend payments.  If the business is not performing, they face the risk of losing their capital.

Debt is a liability meaning it represents a present obligation for the borrower. Debt financing is harder to obtain when compared to equity financing. However, in times of low-interest rates, it is a comparatively cheaper source of funding.

Types of Debt Financing

A company may need to raise capital for various reasons. The choice of debt product is dependent on the following factors:

Tenure

Tenure is the length of time before the debt becomes due. Depending on tenure, debt can be categorized as 1) Short-term debt and 2) Long-term debt. Short term debt is debt whose principal is payable within the next twelve months. Long-term debt includes debt instruments whose term is longer than twelve months.

Mode of raising the debt

Companies can raise debt financing in two ways. They can issue securities into the financial markets (public debt) or borrow directly from banks and financial companies (private debt).

Depending on the tenure and the mode of raising debt, the main types of debt products can be grouped into 4 categories.

Secured or Unsecured

Debt can be secured or unsecured. Secured debt is backed by collateral, usually in the form of an asset or a group of assets. Unsecured debt is not backed by any collateral. Typically, secured debt provides higher borrowing limits and lower interest rates as compared to unsecured debt.

By Type of Interest

There are two types of interest rates: 1) Fixed rate and 2) Floating rate. Under a fixed rate, the rate of interest is fixed during the tenure of the debt. Floating or variable interest rates change over the course of the debt agreement. Floating rates could be linked to reference rates, such as  Example of a floating interest rate is LIBOR +1%.

A typical debt contract includes details of the debt product, such as:

• The tenure or maturity of debt
• The interest rate
• Type of interest (fixed/floating)
• The frequency of interest payments
• Collateral involved (if any)

Debt Financing: Things to Consider

Companies opting for debt financing should consider the following: 1) Cost of debt, 2) Proportion of debt financing in total financing.

Cost of debt

A company’s total cost of capital is the sum of its cost of equity and cost of debt. The cost of capital is the required return a company must generate to satisfy its providers of capital. Companies try to reduce the cost of capital through cheaper sources of funding. Debt financing is cheaper than equity financing, especially during times of low-interest rates.

Cost of debt financing is calculated as Effective interest rate x (1-tax rate)

The effective interest rate is calculated by adding up all sources of a company’s debt and dividing it by the total interest expense. The tax rate is deducted from the effective interest rate to reflect the tax savings generated from interest expenses.

Here is some information about a company.

The company’s cost of debt is 3.5%.

Debt Financing as a Percentage of Total Capital

The debt-to-equity ratio measures the relationship between debt and equity financing. It is calculated by dividing the total debt financing by total equity financing.

We calculate the debt to equity ratio of two companies.

Usually, a lower debt to equity ratio is considered better as a very low Debt/Equity ratio will result in high WACC. This increases the returns to equity holders. A debt-to-equity ratio of above 2 is considered risky. In this example, company B has a higher debt-to-equity ratio. Lenders will be apprehensive of giving credit to this company due to default risk.

Conclusion

Companies use debt financing to lower their cost of capital, which in turn increases their returns to shareholders. Another advantage of debt financing is that unlike equity financing, it does not dilute ownership. Interest on debt is also tax-deductible, which results in an increase reported net income.

However, debt financing exposes firms to adverse changes in interest rates. Any increase in interest rates reduces net income. Companies should choose debt financing prudently based on their cash flows, their ability to fulfil interest obligations, and the percentage of debt in their total capital.