What is Debt Financing? – Definition, Advantages, Types, and More
Debt Financing Definition
In business administration, Debt Financing is understandable to be measured in the context of corporate finance, in which you provide debt capital to a company or another legal person for a limited period.
Contrasting with this is self-financing, in which equity is made available to the company. Debt instruments are funds from creditors.
Interest and repayments for debt financing are at the expense of liquidity. At the same time, there are specific advantages associated with debt financing
What is the difference between external and self-financing?
- If there is a possibility of repayment, the corresponding balance sheet item is part of the external financing. Therefore include provisions, such as provisions for pensions, for debt.
- The hybrid forms of equity exist as a hybrid between equity and debt.
- These exist when equity capital made available to a company without the lenders being sure the right to exert any influence or to assert residual claims.
What types of debt are there?
Depending on the term, a distinction made between short-term and long-term types of debt financing.
For short-term loan financing includes loans with a maturity of up to one year. Examples include short-term bank loans, supplier credit, customer loans(advances), and public debt as tax liabilities.
Examples of long-term credit financing are bank loans, bonds, and promissory note loans. Another category is credit substitutes. It includes leasing, factoring, franchising, and Forfaiting
Internal finance and external finance
- Another distinction within corporate finance is that between internal investment and external finance.
- Internal financing is available if the source of financing is in your own company. Otherwise, it is external financing.
- It means that external financing can be part of external financing, provided that it carried out via loans.
- Or it is part of internal financing. It is the case when provisions made from profits. As a rule, the more significant part of external financing belongs to external financing.
What are the Advantages and Disadvantages?
Advantages of debt financing
- The remuneration, due to the provision of the debt capital, represents operating expenses and thus reduces the tax liability.
- This tax-reducing effect is not possible with self-financing. Also, companies can use leverage to leverage.
- It describes the effect of an expansion debt on the return on equity and the return on investment for the owners.
- The prerequisite for this is that the return on investment (= total return on capital ) is above the interest rate for the debt.
- For example, a company pays an interest rate of three percent on a bank loan, but it makes a return of six percent on the investment.
Disadvantages of debt financing
- Debt financing associated with higher entrepreneurial risk. A rising debt ratio will contribute to increasing liquidity and refinancing risks in the future.
- Conversely, if the debt ratio falls, the creditors’ default risk reduced because corporate assets increasingly cover the receivables.
- With sales falling, it can be difficult for the company to pay interest and repayments—the risk of insolvency or the indebtedness increases.
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