A Guide to Debt Financing, How It Works, and Its Benefits

A firm (business or professional practice) often needs funds to continue business operations or bridge a small gap in its working capital. At such times, the business uses various ways to raise funds. Debt financing is one of the most common methods of financing a business. It is quick, easy and hassle-free. Read on to understand what debt financing is, how it works, its types and benefits, and more! 

What is Debt Financing?

Debt financing is the process of raising funds from a source (often a bank or a Non-Banking Finance Company) with the commitment to pay it back with interest, within the specified tenure at the pre-decided rate of interest. While we generally think of only banks and NBFCs as the source of debt financing, companies raise funds by issuing bonds, commercial papers, debentures, etc.

How Does Debt Financing Work?

For the borrower, debt financing works just like a regular debt. The borrower (a company in this case) applies for the loan either from a bank, NBFC, etc. The terms of the loan are fixed. These include:

• Loan Amount – The sum to be borrowed. This needs to be calculated by the borrower based on the requirement and affordability.
• Tenure – The duration for which the loan is taken. The tenure needs to be comfortable – neither so long that the borrower gets into a debt trap nor too short that the EMI amount is too high.
• Rate of Interest – The rate at which the borrower will return the loan amount, in the form of an interest payment. The borrower needs to find a lender (or a suitable instrument) that charges an affordable rate of interest.

Also Read: What is Debt Snowball Method & How to Repay Debt by Using Snowball Method?

Different Types of Debt Financing

There are different variations in which debt financing is classified. Some of the common ways of debt financing are mentioned below:

Based on the Collateral Requirement

• Secured - loans that require collateral.
• Unsecured - loans that do not require collateral.

Based on the Functionality

• Instalment Loans – Regular term loans that are borrowed from a bank or NBFC and repaid in EMIs.
• Revolving Credit – The type of credit facility that allows a borrower to borrow money, use it to fund the business needs, repay it and borrow it again whenever required.
• Cash Flow Loans – An unsecured loan that’s used to meet a shortfall in working capital.

Based on the Lender

• Bank/NBFC Loans – These are term loans, the most common form of debt financing.
• Debentures – These are long or short-term loans that are not backed by any collateral but rely on the creditworthiness of the borrower/issuer.
• Bonds – These are generally long-term loans that are backed by collateral.

Advantages of Debt Financing

Here are the benefits of debt financing:

• It is a great way to raise funds and use it for business operations.
• Debt payments are often tax-deductible, unlike other ways of raising funds.
• Since the monthly repayment is known beforehand, it is easier to plan for debt repayment over the entire loan tenure.
• A consistent debt repayment over the tenure of the loan helps build a good credit score for your business.
• Debt financing does not result in dilution of stake for the promoter(s).
• This form of financing is less costly compared to equity financing, despite the real “cost” of equity not being very apparent.
• Debt once repaid is “over”, unlike equity which could remain perpetually “ongoing”.

Disadvantages of Debt Financing

Here’s a list of disadvantages of debt financing:

• Depending on the type of debt, many lenders could ask for collateral. This could be an uncomfortable proposition for a borrower.
• In businesses with irregular or uncertain cash flows, servicing a fixed amount every month through EMIs could get difficult.
•  A wrongly borrowed or wrongly serviced loan can adversely affect your credit score or credit rating.

Short-term vs Long-term Debt Financing

The following table highlights the difference between short-term and long-term financing:

Parameters	Short-term Debt Financing	Long-term Debt Financing
Tenure	Up to 2 years or less	More than 2 years
Interest Rate	Higher	Lower
Documentation	Minimal documents required	Requires additional documents
Collateral	No collateral required	May require collateral for long-term financing like a Home Loan or Car Loan
EMI Amount	Higher EMI due to shorter repayment tenure	Lower EMI as the repayment is spread across a longer time frame
Use of Funds	Can be used for any personal expense	Secured long-term financing may be earmarked for a specific purpose, while unsecured personal loans can be used for any purpose

 

Debt Funding vs Invoice Factoring

The following table highlights the difference between debt funding and invoice factoring:

Parameters	Debt Funding	Invoice Factoring
Nature	Involves obtaining loans for liquid cash	Involves selling outstanding customer invoices to a third party for immediate cash
Type of lending	Form of loan	Not a loan, but a sale of accounts receivables
Repayment	Borrowing business repays the lender directly from its own cash flow, with interest	The finance provider chases repayment through the customer, either recourse or non-recourse financing
Access to Capital	Provides liquid cash through loans	Provides immediate cash by selling invoices at a discounted rate
Dependence on Customer Payment	Repayment is independent of customer payments	Repayment depends on the customer, influenced by the type of financing (recourse or non-recourse)

 

Also Read: Debt Vs. Equity Financing: Which is Best for Small Businesses?

Debt Financing vs Equity Funding

The following table highlights the difference between debt financing and equity financing:

Parameters	Debt Financing	Equity Funding
Meaning	Borrowing of debts	Raising share capital by offering shares to the public
Sources	Bank loans, corporate bonds, mortgages, overdrafts, credit cards, factoring, trade credit, insurance lenders, asset-based companies, etc.	Angel investors, corporate investors, institutional investors, venture capital firms, retained earnings, etc.
Interest Rate	Fixed interest rate	No fixed interest rate
Duration	Fixed duration for repayment with a maturity date	Undetermined duration with no maturity date
Risk Level	Higher	Lower
Control	Lenders do not gain the right to influence management unless mentioned in the agreement.	Equity holders have the right to influence management.

 

To Conclude

Embracing debt financing brings more benefits than drawbacks, making it a smart choice to elevate your business. Consider the pros and cons of debt financing before applying for one.  Elevate your business by securing a Business Loan from Poonawalla Fincorp, where a straightforward application, friendly eligibility terms, appealing interest rates, flexible repayments, and top-notch customer service await you.

Frequently Asked Questions

• What is an example of debt financing?

The examples of debt financing are term loans, bond issuance, debentures, commercial paper and credit lines.

• How does debt financing work?

In the case of debt financing, the borrower borrows an amount from the lender at a pre-determined rate of interest and repayment tenure. Rate of interest and tenure can change over the period of the loan. Also, the lender(s) can be banks, NBFCs, individuals or a consortium. The loan is repaid in the form of EMIs over its tenure.

• What is debt vs equity financing?

Debt financing does not result in dilution of stake for the promoter(s), while equity financing almost always results in stake dilution. Debt is repaid over a certain tenure while equity remains “unpaid” till the time the issuer buys back the equity. Also, debt has a much lower cost compared to equity.

Disclaimer

We take utmost care to provide information based on internal data and reliable sources. However, this article and associated web pages provide generic information for reference purposes only. Readers must make an informed decision by reviewing the products offered and the terms and conditions. Loan disbursal is at the sole discretion of Poonawalla Fincorp.
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