What is Debt Funding and Why Should You Choose it?

A business can raise funds by borrowing through debt funding. Although debt can take many different forms, it typically includes borrowing money that is frequently secured against a physical object. Many firms seek debt funding for expanding their business, exploring new markets, etc. At a predetermined future time, the debt is repaid with interest. Ideally, your company should have a solid financial history before seeking financing.

This article is a complete guide to debt funding – how it works, its features, types and terms, benefits and limitations. Read on!

How Does Debt Funding Work?

Debt is, at its core, a transaction between a company (the borrower) and a lender. Upon meeting specific requirements and agreeing to certain agreements, the lender will release a capital sum to a business.

The terms will specify a repayment schedule, which may include making one large payment in the future (bulk payments) or making several smaller payments over a predetermined length of time. They will also indicate any penalties for late payments as well as the amount of interest that must be paid in addition to the capital borrowed.

After a funder and a client have agreed on debt financing, the business can use the extra liquidity to support the business plans they discussed with the funder right away.

Features of Debt Funding

1. Low Risk

Debt funds have the lowest risk because share market swings do not immediately affect them. Debt funds are impacted by the economy’s interest rate regime and its changes. The fluctuations in interest rates, however, are not as extreme as those in the stock market.

2. Low Capital Appreciation 

The investment tries to offer secure and consistent returns. They make investments in fixed-income assets that offer a consistent rate of interest. The corporation that issued the debt simply pays back the loan’s principal.

3. Pre-set Duration

The underlying bonds and debt instruments in the debt mutual fund have a set maturity date. The duration of all fixed-income securities is fixed.

Types of Debt Financing

The main forms of debt financing in India are as follows:

1. Bank Loan

The most typical kind of debt financing is a bank loan. Banking loans include:

2. Secured Loans

The assets of the business are retained as a deposit or collateral with the lender. Secured loans feature low-interest rates since the collateral reduces the lender’s risk.

3. Unsecured Loans

The loan is not secured by any property. The lender thoroughly considers the company’s financial situation and growth prospects before approving the loan.

4. Debentures

Debentures are a type of debt instrument that businesses and governments use to issue loans. Based on their reputation, corporations are given loans at a fixed interest rate.

5. External Commercial Borrowings (ECBs)

ECBs are loans obtained by Indian corporations through the issuance of bonds or loans convertible into foreign currencies. The money raised through ECBs is typically utilized for things like funding working capital, buying capital assets, paying off current debt, or refinancing it.

Depending on the health of their cash flow and the significance of keeping ownership control, businesses may pick the most accessible loan funding option.

Why Choose Debt Financing?

1. Increasing Debt Gives You More Control

You have to pay interest on the amount you borrow when you take out a business loan. The advantage is that you have total authority over your company for the duration of the term. Conversely, when you choose equity. In exchange for money, you permanently relinquish some of your business’s control. Calculating the total income flow you would have to forgo in the event that you chose to give up equity is a straightforward technique to determine which alternative prevails. You can be guaranteed that getting a company loan is a much better option if the amount surpasses the cost of debt.

2. Debt Helps Effective Money Management

When a business has abundant funds, it is simple to become complacent. You’ll learn to be more careful with business spending if you take out a loan. When you choose a business loan, you budget your money to pay it back and only spend when absolutely essential. Additionally, if your company’s credit score isn’t good enough, obtaining a business loan and making on-time payments will raise it. When you eventually apply for a high-value loan, this will be helpful.

3. Debt Can Facilitate Tax Savings

Dividends are an appropriation of earnings; thus, you cannot take advantage of any tax advantages while raising money by giving up stock. The interest you pay on a business loan is deducted from your profits and is seen as an expense of your business. Dividends are not deductible from your net earnings, although this interest is. As a result, both your tax obligation and your company’s taxable income decrease. With these advantages, your company can easily decide to use a business loan to fund operations.

Also Read

Commercial Loans: Eligibility, Types, Benefits, Working And Application Process

What is Debt Restructuring and How Does it Work?

Advantages of Debt Funding

1. Retention of Ownership

When a corporation raises money, it does not transfer any ownership to the lender; only the principal and interest are due. As a result, lenders have no influence over how the business is run.

2. Tax Deductions

Unlike personal loans, the interest and fees for company loans are deductible from income. The tax payment is decreased because interest payments are tax-deductible. The only commitment a corporation has to its lender is to make repayments in accordance with the schedules set forth.

3. Accessible to all Company Types

For businesses of all sizes, debt financing is a simple and readily available source of capital. Because principal and interest payments are fixed, it is easier to plan the budget for each month, quarter, or year. 

4. Owners Retain Operational Authority

You do not have to give up ownership interests in the company in order to acquire capital, which is a significant benefit of obtaining debt financing. Contrary to equity financing, the current management team still has full authority over all corporate decisions and operations, providing reassurance.

5. Plans for Flexible Repayment

A business may track cash flows and make future expansion plans when interest and repayment schedules are clearly laid out before. You will have more accurate monthly repayment information, enabling better planning and budgeting.

6. Flexible Possibilities

There are several corporate uses for long-term debt, including MBOs, shareholder transactions, property expansions, and growth capital.

Disadvantages of Debt Financing

Loan or debt repayment is a requirement that must be made to the lender under penalty of law. Even before paying equity shareholders, lenders must be paid first in the event of bankruptcy.

1. Collateral

Lenders demand that assets serve as collateral for loans. Lenders may require even personal assets to be connected as collateral if the company’s assets are insufficient.

2. Credit Rating

Financing for large debts may have an impact on your credit rating. Because lenders are taking on more risk as a result of the company’s credit rating decline, borrowing costs may rise. The company’s reputation and credit ratings can suffer even from a minor interest payment delay.

3. Influences Your Credit Score

Your credit score will be affected by each small business loan you take out. Be careful because it can lower your grades. Therefore, when you apply for a loan, find out from your lender whether the credit check that was done to prequalify would have an impact on your score.

How Debt Finance Operates

Depending on the type of loan you’re looking for, you can think of debt financing as being divided into two categories: long-term and short-term.

1. Debt Financing for Long Term 

• The majority of the time, long-term debt financing is used to finance the acquisition of assets for your company, such as machinery, buildings, land, or equipment. In most cases, a lender will demand that the assets being purchased serve as collateral for long-term loans.
• With long-term debt financing, the expected useful life of the assets and the scheduled loan repayment often have three to seven-year durations. The SBA will guarantee loans for up to ten years. Most likely, fixed interest rates on long-term debt will translate into regular monthly payments with excellent predictability.

2. Debt Financing for Short Term

• Short-term debt financing typically refers to capital required for a company’s ongoing operations, such as buying merchandise, and supplies, or paying employees’ salaries.
• Because the scheduled repayment is due in less than a year, short-term financing is also known as an operating loan or a short-term loan. An illustration of short-term debt financing is a line of credit. Additionally, often secured by assets are lines of credit (or collateral). 
• Short-term bank loans, lease payments, income taxes payable, accounts payable, wages, etc. are typical forms of short-term debt financing. Businesses that frequently experience short-term cash flow problems when sales don’t pay current costs frequently turn to short-term finance. Cash flow management problems are especially common in new firms.

Debt Financing Terms of Repayment

Repayment refers to the act of returning money that has been borrowed from a lender. The return of funds often occurs through recurrent payments that comprise both principal and interest. The initial amount borrowed in a loan is referred to as the principle.

Businesses look for long-term debt finance to buy assets like structures, machinery, and equipment. Typically, the assets that will be purchased are also used as collateral to secure the loan. The loans have fixed interest rates and regular monthly installments, and the payback period is often up to 10 years.

Who Should Invest in Debt Mutual Funds?

For investors who have a low-risk appetite but want steady income, debt funds may be the right choice. Debt funds are less volatile than equity funds and carry a lesser risk. Debt mutual funds may be a better alternative if you have been investing in conventional fixed-income products like Term Deposits and are seeking constant returns with little volatility. They assist you in reaching your financial objectives in a more tax-efficient way and, as a result, produce higher returns.

It depends on what the investors want. Different types of investors put money into various debt fund types. For instance, if someone wishes to keep his emergency savings in a liquid account, they can.

Generally speaking, one’s emergency fund should equal 3-6 months’ worth of living expenditures, depending on their age. It should be sufficient to have what provides you the assurance to handle emergencies in your home. Anything more can even have an impact on your portfolio of investments. Gather money for around six months’ worth of costs for individuals in their 20s and 30s who might need it more, whilst those who are getting close to retirement would not need as much since they will have built up their reserves.

Final Word

What you may and cannot accomplish with your firm in the future will depend on the finance choice you choose right now. It’s critical to be aware of all your funding alternatives throughout those crucial early years, following launch and before reaching full traction. Consider your company’s destination in one, five, or ten years. Also consider the amount of time, control, or money you’re willing to forfeit to get there.

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