In the business world, expanding existing projects and investing in new ones without external funding is impossible. There are several ways through which a business can raise funds, including debt financing. It is a widely-used source as it is easy, quick, and hassle-free. It is a simple process that involves borrowing money from lenders and investors and repaying it after a specific period, along with interest. Do you want to know more about it? Here is all that you want to know about debt financing meaning, types, and examples.
When a company borrows money from a bank, non-banking financing companies, lenders, or investors to be paid at a future date with a pre-decided interest, it is called debt financing. The money borrowed is repaid in regular installments over a period of time. The lender charges interest on the principal amount as an incentive for lending funds. Payments made to repay a loan are tax-deductible. Debt-based financing is often used when a company needs immediate capital without giving up ownership.
Types of Debt Financing
There are many types of debt financing. Here are the most important ones.
This is the most common type of debt financing. Banks or financial institutions like Indiffi lend money to companies. The company is entitled to pay interest until the principal amount is repaid. The interest rate varies depending on several factors, like the period of the loan, prevailing market conditions, and the creditworthiness of the company.
Loans can be short-term or long-term, depending on the repayment period. Short-term loans are usually repaid in a year or less, whereas long-term loans have a repayment period extending more than a year.
Moreover, loans can be secure or insecure. The company’s assets are kept as collateral security in a secured loan. In case of failure to repay, the lender can sell the asset. A lender gives unsecured loans without any collateral security. The loan is given based on the growth potential of the business entity. Digital lending platforms like Indifi gather data about the past and current performances of the company, analyze them, judge their creditworthiness, and provide loans.
Bonds are one of the debt instruments. They are debt securities issued by companies or governments to raise money. Bonds have a maturity date, and the issuer has to repay the principal amount at maturity and periodic interests to the bondholders. The interest rate can be fixed or variable. Bonds can be short-term, medium-term, or long-term.
Short-term bonds mature within one to three years.
Medium-term bonds reach maturity in 10 or more years.
Long-term loans mature in 30 years or more.
When a company sells bonds to a lender, the buyer becomes a creditor and gets a claim to its assets.
The main difference between a bond and a debenture is the collateral security. Bonds are usually secured loans, whereas debentures are unsecured. Debentures are not backed by collateral securities. So, the risk factor is high for the lender. As the risk is high, the interest rates are high for debentures when compared to bonds.
- Lines of credit
It is an agreement between a bank or a non-bank financial institution and a company. A borrowing limit called the line of credit is preset and agreed upon by the lender and borrower. The company can borrow money whenever needed until the limit is reached. It has to pay interest only for the amount borrowed. They are suitable for managing short-term financial needs like operational expenses.
It is a popular type of debt financing where the company gives the lender the right to use its asset in exchange for the money borrowed. The lender is called the lessee under a lease contract. The ownership of the asset remains with the company, and the asset is returned back by the lessee at the end of the lease contract period. It is advantageous for the business as it can enjoy tax benefits.
Table showing types of debt financing
|Loan||Principal to be repaid with interest can be short or long-term and secured or unsecured||Bank loans, mortgage loans|
|Bonds||Debt instruments issued by companies with maturity dates and periodic interests.||Government bonds, corporate bonds|
|Debentures||Unsecured loans, high interest||Treasury bills issued by governments|
|Line of Credit||Money borrowed from financial companies with a preset limit, interest for the borrowed amount only||Business Equity|
|Leasing||Right to use an asset for a specified period of time in return for the amount lent, no change in the ownership||Building and machinery lease|
Examples of debt financing
Loan – XYZ Co. wants to get a loan to buy new machinery. They get a loan for 2,00,000 from a financial institution at an interest of 10% per annum for five years. If there is a specification of the monthly repayment, the amount calculated will be repaid every month for five years. If not, the borrowed amount will be repaid at the end of the term, along with the interest.
Bond – ABC Co. issues a 5-year bond for 100000 at the rate of interest of 5%. The interest rate is paid annually or semi-annually, depending on the contract agreement. When the bond matures, the company has to repay the investor the face value of the bond.
Debt financing plays a significant role in the growth and expansion of a company. Understanding the pros and cons of various types of debt financing is important to achieve business goals. A digital platform like Indifi gives multiple choices of debt financing to businesses. They increase the chances of getting loans and minimize risk. Find the right lender to have a hassle-free experience.
- What are the main types of debt financing?
Loans, bonds, debentures, lines of credit, and leasing are the main types.
- Which is better – a bond or a debenture?
It depends on several factors like risks, returns, market conditions, preference of investors, security, etc.
- What are the factors that increase the chances of loan approval?
Good credit scores, proper maintenance of accounts, appropriate documentation, steady growth, and stable growth are important factors.