Debt financing is the process of raising money in the form of a secured or unsecured loan for working capital or capital expenditures. Firms typically use this type of financing to maintain ownership percentages and lower their taxes.
What Does Debt Financing Mean?
What is the definition of debt financing? Debt financing is borrowing money from a third party, i.e. a financial institution, with the promise to return the principal with an agreed interest. Startup companies and smaller firms use debt as a way to leverage their operations and maintain ownership of their business.
The greatest advantage of financing with is the tax deductions, as in most cases, debt related interest payments is viewed as a business expense on the firm’s balance sheet. On the downside, an increase in the interest rates will have an impact on the loan repayment and on the credit rating of the borrower. Also, the firm uses its assets as collateral for the loan to obtain a higher line of credit; thereby, in the case of a default, the borrower may be required to repay the remaining loan and interest in cash.
Characteristics of Debt
Debt can come in a myriad of forms, all of which represent combinations and permutations of a fairly small number of characteristics. Know those characteristics, and you can make sense of – and compare – any form. The key characteristics of debt include the following:
- Intended use of funds
- Anticipated source of repayment
- Term and duration
- Risk mitigation
Intended Use of Funds
Business loans tend to be designed to accommodate three primary uses: working capital, equipment, and real estate. As a rule of thumb, the maturity of the loan should coincide with the lifecycle of the asset to be financed. For instance, be wary of financing long-lived equipment with short-term loans designed for working capital. In such a circumstance, the need for the financing is likely to extend beyond the maturity of the loan, which creates refinancing risk.
Primary Source of Repayment
Although most lenders anticipate repayment of their loans with the free cash flow generated by the borrower in the normal course of business, asset-based lenders look to the liquidation of specific assets for repayment. Factoring, for instance, is a form of short-term financing that looks to the collection of specific accounts receivable for repayment. While cash flow lenders are primarily concerned with the viability of the borrower, asset-based lenders can be more concerned with the viability of the borrower’s customers.
Term and Duration
The term and duration of a loan is another differentiating characteristic. Short-term loans (those having a maturity of a year or less) are best suited to fund episodic or seasonal working capital needs.
Consider the case of a manufacturer of snowboard bindings. Stocks of inventory ramp up in the Summer and Fall, when bindings are being manufactured for the upcoming season. As a consequence, cash reserves get drawn down. As the manufacturer’s wholesale customers sell products to consumers in late Fall and early Winter, the manufacturer collects accounts receivable, and its cash stock goes back up. As a result, the snowboard binding manufacturer’s cash balance goes up and down over the course of the year in a predictable pattern.
In this example, the manufacturer would be well-served by a short-term line of credit that would cover the borrower’s cash shortfall between June and January in anticipation of a seasonal cash surplus in the late Winter and early Spring.
Long-lived assets such as equipment and real estate are best financed with correspondingly long-term debt (having a maturity of more than one year). That’s why mortgages, for instance, can have 20 or even 30-year maturities. Somewhat more surprisingly, the rapid and sustained accumulation of accounts receivable and inventory experienced by a rapidly growing company can also create the need for long-term financing.
Usually, but not always, the cost of debt is expressed in terms of an annual percentage rate. The advertised rate is sometimes known as the nominal rate, because interest is usually not the only cost. A variety of fees and discounts add to the total effective cost of a loan.
The best way to compare costs of different loans is to calculate the annual percentage rate or “APR.” The APR takes into account the timing and amount of all loan costs. If a lender won’t tell you the APR on a loan, you might want to consider a different lender.
The cost of a loan is a function of a variety of factors including, but not limited to, the following:
- Administration costs
- Cost of funds
Banks, for instance, are highly regulated but have access to low-cost deposits guaranteed by the Federal government. Asset-based lenders, historically, have had high loan administration costs (though the application of technology is lowering the cost for some online lenders). Alternative lenders, in general, have a relatively high cost of funds, which contributes to their need to charge proportionately higher rates to borrowers. Of course, the interest rate on risky loans will reflect a “risk premium.”
Different lenders will seek to manage – or mitigate – risk in different ways:
- Seniorityand subordination describe the relative position of different lenders in the payment queue. Senior lenders are at the front of the line, while subordinated lenders are farther back.
- Collateral, guarantees, and securityrepresent “second ways out” of a loan by a lender—a “bite at a second apple,” if you will. Small business owners are often asked to provide personal guarantees of their business loan obligations. In certain circumstances, a third party such as the Small Business Administration will provide partial guarantees of a loan. As a general rule, banks and other secured lenders will seek collateral in the form of assets that have value independent of the ongoing performance of the borrowing company. That’s why accounts receivable and real estate tend to be more highly valued as collateral than are specialized equipment or unique finished goods inventory.
- Covenantsare promises of performance (e.g. minimum current ratio or periodic operating cash flow) or prohibitions of specific actions (e.g. payments to shareholders above a threshold amount). The “breach” of a covenant can trigger a “default.” Uncured defaults can, in turn, give the lender certain rights, including the right to foreclose on collateral assets.
Price and loan duration are relatively straightforward. The bulk of a loan agreement’s “fine print” will consist of attempts on the part of the lender to mitigate its risk. With time and experience, you’ll come to recognize which elements are negotiable. When in doubt, it’s often a good idea to retain the services of an experienced business lawyer.
Types of Debts
Mortgage-Related Debt Versus Consumer Debt
For people in or approaching retirement, there are two main categories of debt: mortgage-related debt and consumer debt. Mortgage-related debt covers home-related borrowing, while consumer debt includes all other types of debts (e.g., credit cards, student loans, car loans).
- Primary mortgage: a method of borrowing to purchase a home
- Home equity loan: a one-time method of borrowing against the equity in a home
- Home equity line of credit: a renewable method of borrowing against the equity in a home
- Reverse mortgage: a method of borrowing against the equity in a home available only to homeowners age 60 and older
- Installment loan: typically a method of borrowing a fixed amount of money for a large purchase, such as a car
- Student loan: a method of borrowing to pay for higher education expenses
- Credit card loan: a renewable method of borrowing for nearly any type of consumer expense (food, gas, health care costs, entertainment, etc.)