Pros & Cons of Debt Financing
Debt financing is a means of obtaining funds from an investor or lender by borrowing money. Parties involved in debt financing establish a borrower-lender relationship in which one party -- the company -- borrows money from another party -- the bank -- and promises to repay the sum at a specified date in the future. The borrower has to repay the loan to the lender, along with stated interest, in monthly installments.
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Equity Financing Vs. Debt Financing
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A business can raise money in two ways: equity financing and debt financing. Equity financing entails selling off a part of the business, whereas in debt financing, the company borrows money from an external source. When a business uses equity financing, it issues and sells certificates of stock that transfer ownership of part of the company to the investor. As part owner, the investor is entitled to the business's profits, commensurate with his ownership stake. The portion of profits may be paid to shareholders periodically in the form of dividends. In debt financing, the company borrows money from a bank or by issuing bonds. The company does not have to give up ownership of part of the business, but it has to make regular payments of principal and interest. Each financing method has its advantages, and it is up to the particular company to determine which financing best suits the objectives of the business.
Ownership and Control
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The most apparent benefit of debt financing is that it enables a company to retain ownership. As absolute owners, the founders of a business will have total control over operations and management decisions. Debt financing also allows a company to have more financial freedom. This is because, as soon as a loan is repaid at the end of the repayment period, the borrower-lender relationship ceases to exist and the lender does not have any stake or claim on the borrower. In equity financing, the investor who bought the company's stock will always have a claim.
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Credit History
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Another advantage of debt financing, especially for new and small businesses, is that responsible borrowing and repayment may bolster the borrower's credit rating, making subsequent loan processing easier. Debt financing is easier to manage and administer because its associated reporting requirements are not as complicated as requirements for equity financing. Additionally, debt financing is less expensive than equity financing over the long term.
Late Payments and Penalties
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The foremost limitation of debt financing is that borrowers are required to make a steady stream of payments to the lender. A company that takes a loan from a bank will have to repay the loan by making monthly payments on principal and interest. This may be a considerable financial burden if the business has multiple loans, or if the business suffers from seasonal cash flow problems. Depending on the lender, a delinquent borrower may have to pay a steep price for late payment, or may have its collateral possessed. Late payment not only costs the borrower but also hurts its credit rating. In addition, debt financing may not be the most viable avenue of raising funds for new businesses because lenders are not as willing to extend credit to an unproven establishment. In many cases, a business applying for a loan may be approved for an amount that is significantly less than what it applied for, meaning the business would have to pursue other financing sources.
Interest
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Debt financing involves interest. From the borrower's perspective, the interest is the cost of the loan; from the lender's perspective, it is the compensation for carrying the risk associated with lending money. The rate of interest a lender charges for a loan reflects the level of risk. For example, a bank may charge higher interest to a newly established company than a company that has been successfully operating for a decade. This is because lending money to a new and unproven company entails higher risk for the lender.
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References
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