The Definition of Debt Finance
Debt financing helps a variety of organizations finance short-term operating needs, long-term investments, major expansion projects, and mergers or acquisitions. Debt financing also helps an organization take advantage of low interest rates available in capital markets. Groups that use debt funding include governments, nonprofit entities---such as charitable foundations---business companies and individuals.
Other People Are Reading
-
Function
-
An organization---such as a government, a company or a nonprofit---uses debt to finance operations, invest in short- or long-term expansion projects or engage in a corporate reorganization deal such as a merger or an acquisition. A firm also could use debt if interest rates are low or other funding sources---such as equities---are expensive. For example, the U.S. Treasury Department could issue $1 billion in T-bonds to finance a major infrastructure project such as a bridge or an airport.
Types
-
There are many types of debt finance agreements but the most common are term loans, overdrafts, credit lines, commercial paper instruments, bonds and quasi-bonds. A term loan is a bank loan that a firm reimburses on a monthly basis. An overdraft is an arrangement that allows a bank's customer to withdraw more than available balances and reimburse later. A line of credit is a permanent loan that is always available to a client after reimbursement. Commercial papers, bonds and quasi-bonds are capital market instruments. Borrowers pay investors monthly interest payments and initial amounts loaned at maturity.
-
Significance
-
Modern economies depend on debt finance to develop. Many institutions and individuals use debt to fund purchases, investments or long-term expenses---such as school tuition. A government could issue debt products to balance a budget. A nonprofit might seek a loan to purchase new supplies for upcoming charitable activities. A company could use an overdraft agreement to pay suppliers. For instance, FairyTale & Co might issue $2 million bonds, at 7 percent interest and payable in 2030, on the New York Stock Exchange.
Benefits
-
Debt financing helps an organization receive affordable financing when market conditions are favorable without losing ownership. In other words, issuing debt allows a company's owners to hold the same voting rights. A company could use debt to finance strategic investment activities immediately and schedule a payment plan in the long term. Financial institutions---and capital markets---also gain from debt financing because they make profits and traders also may trade debt instruments. For example, Bank ABC could lend to XYZ Co., sell that loan on capital markets and make a double profit (interest on XYZ loan and commission on loan sale).
Capital Structure Factors
-
"Capital structure" and "working capital" concepts help a corporate finance specialist gauge an organization's financial standing, appraise its funding needs and recommend financing alternatives. "Capital structure" indicates various sources a company uses to fund operating activities---that is, internal funds, stocks and bonds. "Working capital" is a measure of short-term cash availability and equals current assets minus current liabilities. A corporate finance analyst partners with treasurers and investment bankers to propose funding solutions to management.
-
References
- Photo Credit debt defined image by Christopher Walker from Fotolia.com
