Parameters of Debt Financing

Parameters of Debt Financing

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Debt financing occurs when a corporation borrows money to be repaid at a later period with interest. It can assume the silhouette of both an unsecured loan and a secured loan. Loan is taken to finance acquisitions or, operating capital and here the term “Debt” alludes to the money that must be paid back. On the contrary, financing alludes to cash provision for utilization within commercial operations.

Debt financing is a time-limited activity in which the borrower must repay the loan plus interest at the end of the agreed-upon period. Payments might be made monthly, semi-annually, or at the conclusion of the loan term. Another crucial aspect of Debt Financing is that the loan is secured or collateralized with the assets of the firm accepting the loan. This is frequently included in the secured loan. If the loan is unsecured, the credit line is generally lower.

If a corporation requires a large loan, Debt Financing is utilised, in which the company's owner attaches part of the firm's assets and a loan is granted depending on the worth of those assets. Let's look at Debt Financing via the lens of an example. If a corporation needs a Rs 10 crore loan, it can raise the funds by issuing bonds or notes to institutional investors. Debt financing is a costly method of acquiring capital since the firm must engage an investment banker to organise large loans in a methodical manner. When interest rates are low and yields are high, it is a feasible alternative. A corporation uses debt financing since it does not have to put up its own capital. However, too much debt is harmful, therefore businesses must determine a level (Debt to Equity ratio) that they are comfortable with.

Debt Financing Merits

1. Safeguard business ownership - The major reason that corporations opt to finance through debt rather than equity is to protect company ownership. The investor keeps an equity ownership in the firm when using Equity Financing, such as selling ordinary and preferred shares. The investor then acquires voting rights as a shareholder, and firm owners' shareholding is diluted. A lender provides debt capital and is solely entitled to return of capital plus interest. As a result, business owners can maintain full ownership of their firm and terminate their obligations to the lender once the debt is paid off.

2. Interest Payments that are tax deductible - Another advantage of debt financing is that interest payments are tax deductible. It reduces the company's tax liabilities. Furthermore, if the loan is repaid at a steady rate, the principle payment and interest expenditure are set and known. It enables reliable forecasting, which simplifies budgeting and financial planning.

Debt Financing Demerits

1. The requirement for consistent income - For some business owners, debt repayment might be difficult. They must verify that the firm generates enough income to cover regular principle and interest payments. Many lending organisations additionally require the posting of business assets as collateral for the loan, which can be taken if the firm fails to make specified payments.

2. Negative influence on credit scores - If debtors do not have a strong strategy in place to repay their debt, they will suffer the repercussions. Late or missed payments will harm their credit scores, making it more difficult to borrow money in the future.

3. Bankruptcy - Agreeing to offer collateral to the lender puts their corporate assets, and sometimes even personal assets, at danger. Above all, they risk becoming bankrupt. Even if the firm fails, the debt must be repaid.