What is debt financing?
Definition: Debt financing is a way companies get money to expand, acquire a new company, finance their endeavors, etc. Companies acquire the capital they later return with interest through bank loans, credit cards, bonds, etc.
The debt financing type usually depends on the company’s cash flow, credit card history, and customer return rates.
Companies opt for debt financing usually because of lower interest rates, tax deductions and preserving full ownership over the company. Bigger companies have a higher chance with banks, while middle-size and small companies have to look into other options.
How does debt financing work?
The company applies for a loan, usually sending documentation regarding its business. Banks are mostly interested in the profit and investment history of the company, while other borrowers may focus on customer return rates, online reviews,etc.
The lender assesses the company based on its application, focusing on its ability to repay the debt. The assessment period usually takes 3-5 working days.
If the company’s loan gets approved, the lender provides the funds, and the company agrees on the repayment schedule and interest rate.
Depending on the type of debt financing, repayment can be short-term or long-term. The details are worked out during the debt financing agreement.
Types of debt financing
Installment loans are a long-term type of debt financing because the company receives the funds upfront and then repays the lender with interest over a period. Examples of installment loans:
- Bank loans
- SBA loans
A short-term debt financing option because the company doesn’t get a sum upfront but has access to a set credit line with a maximum credit limit. The credit line resets when the company repays the borrowed money. Examples of revolving loans are:
- Business lines of credit
- Credit cards
Cash flow loans
A short-term debt financing option focused on providing capital based on the company’s cash flow rather than credit history. An example of a cash flow loan is when a company sells an invoice to a factoring company, and once the client pays the invoice, the company gets a deducted amount. Other examples:
- Invoice financing/factoring
- Merchant cash advance
Example of debt financing
Bonds are a long-term debt financing option, where the company issues bonds ( debt securities) to lenders ( investors) and, in return, gets the investment. The investor gets a complete return on investment upon the maturity date ( usually after ten years) but profits on the interest earned during that period.
Microsoft and Facebook.Inc are examples of successful companies that got debt financing through bonds to expand their business.