Debt financing is the result of a company raising capital expenditure by selling debt instruments to institutional investors or individuals. The organization then promises to repay the principal along with the interest and the investor or individual, as the case may be, effectively becomes a creditor of the company. Another way companies can raise funds in a debt market is through equity financing by the way of issuing shares in a public offering.
What exactly is debt financing?
A company that requires capital has three ways of raising finances. It can opt for the equity route, the debt route, or a hybrid of both. Equity in a company is a form of ownership as the individual or institutional investor holds a small stake in the company. Thus, the equity investor has a claim on the future earnings of the company. However, it is to be noted that equity shareholders are the last to be paid if the company goes bankrupt. The other popular way to raise finances is through debt also known as debt financing.
The company issues bonds, bills, and notes to raise finances via debt financing. The institutional investor or the individual who purchases the bond then becomes a creditor to the company. The company then is beholden to the creditor and agrees to pay back the principal along with the interest at a pre-decided time in the future. However, if the company declares bankruptcy, the creditors are given priority over the equity shareholders when it comes to claims made on liquidated assets.
Capital structure and debt financing
A company’s capital structure is made up of a combination of debt and equity. It is important to know the cost of equity and of the debt to make profits and pay back investors, creditors, and shareholders. The company’s cost of equity is the dividend it pays to the shareholders, and the cost of debt is the interest payments made to the creditors as they represent the amount or the cost of borrowing. These interest payments or coupon payments are paid to the bondholders annually.
Equity financing combined with debt financing represents the cost of capital to the company. The company, before setting up operations or running a business, must forecast whether their investment will bear fruit and whether they will be able to make an adequate return on investment (ROI) to meet the cost of capital. If they are unable to make sufficient returns or if the gestation period is too long, they should refrain from investing. The returns generated must be greater than the cost of capital as this will indicate positive earnings for the company’s investors.
Conclusion
A metric often used by analysts to measure how much of the company’s capital is financed by debt is the debt-to-equity ratio (D/E ratio). Most experts agree that a low D/E ratio must be maintained unless a company has a high tolerance for debt.
