Debt Financing - Explained
What is Debt Financing?
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Table of ContentsWhat is Debt Financing?How Does Debt Financing Work?Debt in the Capital StructureCalculating Cost of Debt
What is Debt Financing?
Businesses can raise operational capital (or other sorts of capital) by selling debt instruments like bonds, debentures, and other types of debt security. The act of raising capital by selling debt instruments is called debt financing. The individuals and organizations become creditors of the issuing company by lending capital against the debt instruments. The creditors are entitled to receive interest against the loan and get back the principal amount after a specific period of time.
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How Does Debt Financing Work?
Companies sell debt instruments in forms of bond, note or bills in the market to raise capital for running the operations of the company and to expand it. Those can be purchased by individuals or by investing firms. The creditors have a greater claim on the liquidated assets than that of the shareholders during of insolvency. Another way of raising capital in the debt market is issuing equity shares in the market. That is called equity financing. Equity shares represent a percentage of the ownership of the company. The shareholders are entitled to receive a percentage from the company's future revenues, but they do not get back the principal amount. In case of insolvency, the shareholders are the last ones to receive any money.
Debt in the Capital Structure
A company's capital structure is comprised of equity and debt. A percentage of the revenue is paid to the equity shareholders as dividends, on the other hand, the bondholders receive interests against the loan. The former is called the cost of equity and the later is known as the cost of debt. This comprises the company's cost of capital. A company needs to ensure they can cover the cost of capital with their return. They strategize all their expenditure, expansion and investments keeping this in mind. If a company fails to generate positive income for its financiers, they need to review their capital structure.
Calculating Cost of Debt
The formula for calculating the cost of debt financing is, Cost of debt = Interest Expense * (1 - Tax Rate) The interest rate is generally tax deductible, so the interest expense is calculated after deducting the tax amount. A company's debt financing is measured by debt-to-equity ratio. It is a ratio of the capital raised by selling equity shares and the capital raised by selling debt instruments. Generally, a low debt-to-equity ratio is preferred by the businesses but the tolerance to the debt depends on the industry. There are certain rules to be followed by a borrower company regarding financial performance, those are known as covenants. A company needs to adhere to these rules in order to secure their debt financing.