# How Does Debt Financing Work?

> **Definition**
>
> Debt financing involves companies selling fixed-income products such as bonds, bills, or notes to creditors, including investors.

## What Is Debt Financing?

Debt financing occurs when a firm raises money for [working capital](https://www.investopedia.com/terms/w/workingcapital.asp) or capital expenditures by selling debt instruments to individuals and/or institutional investors. The individuals or institutions become [creditors](https://www.investopedia.com/terms/c/creditor.asp) in return for lending the money and they receive a promise that the principal and interest on the debt will be repaid.

### Key Takeaways

*   Debt financing is when a business borrows money, usually through instruments like bonds and loans, that it has to pay back with interest.
*   It is different from equity financing (issuance of stock) because the company retains full ownership but takes on the obligation to repay lenders no matter how the business performs.
*   The upsides of debt financing include tax benefits and keeping control, but too much debt can limit flexibility and scare off future lenders and investors.

![Debt Financing: When a company raises money by selling debt instruments to investors.](https://www.investopedia.com/thmb/eVwWNxJA_DvU9YcOFAPoAPfFT9k=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/debtfinancing.asp-final-fe54890987344fc4bb0120f23cb9abce.jpg)

*Debt financing can benefit businesses by providing them access to capital for various needs while allowing them to maintain ownership and control. — Investopedia / Jake Shi*

## How Debt Financing Works

A company can obtain financing in three ways when it needs money. It can sell equity, take on [debt](https://www.investopedia.com/terms/d/debt.asp), 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 doesn't have to be paid back. Equity holders are last in line to receive money if the company goes [bankrupt](https://www.investopedia.com/terms/b/bankruptcy.asp).

The other way to raise capital in debt markets is to issue shares of stock in a public offering. This is referred to as [equity financing](https://www.investopedia.com/terms/e/equityfinancing.asp).

A company can choose debt financing, which entails selling [fixed-income](https://www.investopedia.com/terms/f/fixedincome.asp) products such as [bonds, bills, or notes](https://www.investopedia.com/ask/answers/difference-between-bills-notes-and-bonds/) to investors to obtain the capital necessary to grow and expand its operations. When a company issues a bond, the investors that purchase it are effectively lenders who are either retail or institutional investors that provide the company with debt financing.

The amount of the investment loan is also known as the [principal](https://www.investopedia.com/terms/p/principal.asp). It must be paid back at some agreed date in the future. Lenders have a higher claim on any [liquidated assets](https://www.investopedia.com/terms/l/liquidasset.asp) than shareholders if the company goes bankrupt.

## Special Considerations 

Several factors influence and affect debt financing.

### The Cost of Debt

A firm's capital structure consists of equity and debt. The [cost of equity](https://www.investopedia.com/terms/c/costofequity.asp) is the dividend payments to shareholders, and the [cost of debt](https://www.investopedia.com/terms/c/costofdebt.asp) is the interest payments to bondholders.

A company not only promises to repay the principal amount when it issues debt. It also promises to compensate its bondholders by annually making interest payments known as [coupon payments](https://www.investopedia.com/terms/c/coupon.asp) to them. 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](https://www.investopedia.com/terms/c/costofcapital.asp). It 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. The firm isn't generating positive earnings for its investors if its returns on its capital expenditures are below its cost of capital. The company may have to re-evaluate and re-balance its capital structure in this case.

The formula for the cost of debt financing is:

**KD = Interest Expense x (1 - Tax Rate)**

**where KD = cost of debt**

The interest on the debt is [tax-deductible](https://www.investopedia.com/terms/d/deductible.asp) in most cases, so 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](https://www.investopedia.com/terms/d/debtequityratio.asp) (D/E).

The D/E ratio is $2 billion / $10 billion = 1/5 or 20% if total debt is $2 billion and total stockholders' equity is $10 billion. There's $5 of equity for every $1 of debt financing. A low D/E ratio is generally 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](https://www.investopedia.com/terms/b/balancesheet.asp) statement.

> **Important**
>
> 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.

## Other Types of Debt Financing

Common types of debt financing include more than just issuing a bond. Some options may be harder for small businesses to secure especially if they haven't been in operations for long or if their financial position isn't as strong as those of larger companies.

*   **Term loans**: Term loans involve borrowing a lump sum of capital from a bank or financial institution that must be repaid over a predetermined period. They may have fixed or variable interest rates. These loans are usually structured with regular monthly payments that include both principal and interest.
*   **Lines of credit**: A [line of credit](https://www.investopedia.com/terms/l/lineofcredit.asp) is a flexible loan that provides businesses with access to a specific amount of capital that can be drawn upon as needed. It works similarly to a credit card because businesses only pay interest on the funds they actually use. Lines of credit are particularly useful for managing cash flow, covering short-term operational expenses, and addressing unexpected costs.
*   **Revolving credit facilities**: Revolving credit facilities function much like lines of credit but are typically larger and used by more substantial businesses. These facilities provide a pool of capital that the business can draw from and repay multiple times, but they can't exceed a credit limit up to a certain amount.
*   **Equipment financing**: Equipment financing involves borrowing funds specifically to purchase business-critical equipment, with the equipment itself serving as collateral. This type of loan or lease allows businesses to acquire machinery, vehicles, technology, and other assets necessary for operations without an immediate cash outlay.
*   **Merchant cash advances**: Merchant cash advances provide businesses with a lump sum payment in exchange for a percentage of future credit card sales. This type of financing is popular among businesses with high credit card transaction volumes that need cash immediately. Merchant cash advances can come with higher costs compared to traditional loans, however.
*   **Trade credit**: Trade credit is a form of short-term financing that's extended by suppliers. A company can buy something and then pay 30 or 60 days later. This type of financing helps businesses manage inventory and produce the goods they need, so they have the cash flow to then pay for that invoice.
*   **Convertible debt**: [Convertible debt](https://www.investopedia.com/terms/c/convertiblebond.asp) is a hybrid form of financing where loans can be converted into equity shares in the company at a later date. A company can choose to issue a bond but give the holder the option of later switching from debt financing to equity financing.

## 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 interest rate is determined by market rates and the creditworthiness of the borrower. Higher rates of interest imply a greater chance of [default](https://www.investopedia.com/terms/d/default2.asp) and therefore carry a higher level of risk. They help to compensate the borrower for this increased risk.

> **Fast Fact**
>
> Debt financing often requires that the borrower adhere to certain rules regarding financial performance. These rules are referred to as covenants.

Debt financing can be difficult to obtain but it provides funding at lower rates than equity financing for many companies, particularly in periods of historically low interest rates. Another advantage is that the interest on the debt is [tax-deductible](https://www.investopedia.com/terms/t/tax-deduction.asp). Adding too much debt can increase the cost of capital, however, and this reduces the [present value](https://www.investopedia.com/terms/p/presentvalue.asp) 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 doesn't have to give up a portion of ownership to receive funds.

Most companies use a combination of debt and [equity financing](https://www.investopedia.com/terms/e/equityfinancing.asp). They choose debt or equity financing or both, depending on which type of funding is most easily accessible, the state of their [cash flow](https://www.investopedia.com/terms/c/cashflow.asp), and the importance of maintaining ownership control. The D/E ratio shows how much financing is obtained through debt versus equity. Creditors tend to look favorably on a relatively low D/E ratio, which benefits the company if it has to access additional debt financing in the future.

## Advantages and Disadvantages of Debt Financing

Debt financing comes with some notable pros and cons just like any other type of financing.

### Pros of Debt Financing

One advantage of debt financing is that it allows a business to [leverage](https://www.investopedia.com/terms/l/leverage.asp) a 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 can be tax-deductible.

Debt financing also allows businesses to retain ownership and control, unlike equity financing where ownership stakes are sold to investors. The business owners don't have to give up any control or decision-making power in the company.

Debt financing can be more cost-effective compared to equity financing and the relationship with the lender ends and there are no further obligations when the debt is repaid. Equity investors typically expect ongoing dividends and a share of the profits which can be more expensive in the long run. The only way to extinguish this is through share reacquisition.

### Cons of Debt Financing

The main disadvantage of debt financing is that interest must be paid to lenders, so 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.

High levels of debt can negatively impact a company’s balance sheet and its financial ratios. This can make the business appear riskier to investors and lenders and potentially lead to higher borrowing costs in the future. High debt levels can also limit a company’s flexibility because much of its revenue will be tied up in servicing debt.

Debt financing also often involves restrictive covenants. Lenders may impose conditions that restrict additional borrowing, dictate certain financial ratios that must be maintained, or limit the types of investments or expenditures a company can undertake. This is a [risk management](https://www.investopedia.com/terms/r/riskmanagement.asp) strategy to ensure that the lender has security in how the company is being run.

Pros

*   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
    

Cons

*   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
    

## What Are Examples of Debt Financing?

[Debt financing](https://www.investopedia.com/what-is-venture-debt-financing-6835317) includes bank loans, loans from family and friends, government-backed loans such as SBA loans, lines of credit, credit cards, mortgages, and equipment loans.

## 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 advances and invoice financing are examples of cash flow loans.

## Why Would a Company Choose Debt Financing Over Equity Financing?

Some companies may prefer to keep the equity ownership intact and not dilute stakes in the company by issuing more shares. It may also be more cost-effective to raise capital with debt compared to issuing stock and having to potentially pay dividends in the future.

## Is Debt Financing Good or Bad?

Debt financing can be both good and bad. It's a good option if a company can use [debt to stimulate growth](https://www.investopedia.com/articles/investing/032116/10-companies-no-debt-doxnhtcpayx.asp), but 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 need some form of debt financing. Additional funds allow them to invest in the resources they need 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 they have sufficient cash flow to pay the principal and interest obligations tied to the loan.

> **Article Sources**
>
> 1.  SBG Funding. "[Cost of Debt Explained: Formula, Factors, and Examples](https://sbgfunding.com/cost-of-debt-formula/#:~:text=Cost%20of%20Debt%20Explained:%20Formula%2C%20Factors%20&,of%20Debt%20%C3%97%20%281%20%E2%80%93%20Tax%20Rate%29)."