Debt finance can be considered one of the most critical concepts of the financial industry as it provides an opportunity to obtain financing by borrowing.
However, there are potential risks to consider too. According to EY, the cost of debt has increased significantly, potentially leading to an additional £25bn in refinancing by 2027.
Learning about debt finance, its operational elements, benefits or drawbacks, means that business owners are ready to make the right decisions based on the company’s needs.
In this guide, the focus is on debt finance, how it works, where it can be useful, and the considerations that need to be made. So, what is debt finance exactly?
Debt finance involves raising capital through borrowing. There are two ways through which organisations and individuals can obtain funds – loans and bonds.
In return, they agree to pay back the borrowed sum, referred to as the principal amount with an interest charge within a stipulated time.
What is debt financing?
Debt financing involves the raising of capital which is in turn repaid with interest. This financing can be in the form of bank credit, bonds or credit arrangements.
More importantly, debt financing involves using funds borrowed with the specific understanding that they have to be paid back in accordance with the terms in the agreement.
Debt financing is not like equity financing where investors own a stake in the business while there is no need to give up control or ownership.
When decision-makers within companies decide to use debt financing they make a formal contract with the lender. This outlines the terms of the loan, including the interest rate, repayment plan as well as covenants and conditions.
These terms define the manner and time within which the company will be in a position to repay the amount borrowed as well as the debt that the company will be held accountable for.
We also recommend reading our guide to cash flow problems – how to spot and avoid them.
Types of debt finance
Debt finance can take several forms, each with its characteristics and purposes. For example:
Bank loans (secured and unsecured)
These loans can be applied for any purpose, ranging from working capital to scale up and expand, the purchasing of equipment or even working capital financing.
Banks usually expect business to offer security and prove they have the capacity to repay the amount that is borrowed.
The rates of interest and the period of repayment of the loan always varies according to the financial position of the borrower and the purpose of the loan.
Bonds
Bonds are financial obligations in the form of fixed income securities that are sold by companies or/and governments to the public with the aim of obtaining funds.
When investors purchase bonds they are lending money to the issuer for an agreed period in exchange for periodic interest.
There are different types of bonds based on interest rates, time to maturity and the level of risks associated with them.
They afford companies an opportunity to obtain major credit in a wide market of investors.
Convertible debt
Convertible debt is a type of financing that has features of both debt and equity.
It enables the lender to exchange the debt for stocks of the company at a later time, and this usually comes down to the discretion of the lender.
Due to its features, this type of financing might be of interest for investors who would like to become an owner of shares and while also receiving interest on the loan at the same time.
Commercial paper
Commercial paper is a type of short-term obligation and debt instrument most often used to finance the working capital requirements of the business organisation.
It is an unsecured form of financing that is commonly issued by companies that have a strong credit rating.
Commercial paper is repaid in less than one year; this is normally due to the fact that it is a type of short term debt.
Other types of debt finance include:
- Invoice finance
- Asset finance
- Business credit cards
- Merchant cash advance
- Overdrafts
- R&D tax credit loans
Risks and considerations
While debt finance offers significant benefits, it also comes with risks and considerations that businesses must carefully evaluate:
- Repayment obligations: The obligation to repay debt, including interest, can create financial strain, especially if the company’s cash flow is unstable or insufficient. Failure to meet repayment obligations can lead to default and potential legal consequences.
- Interest costs: The cost of borrowing, including interest payments, can add up over time. High-interest rates can increase the overall expense of the debt and impact the company’s profitability.
- Covenants and restrictions: Lenders may impose covenants or restrictions as conditions for the loan. These may include financial performance requirements or limitations on additional borrowing.
Compliance with these conditions can limit the company’s flexibility and operational freedom.
Also, read our guide explaining what bad debt is in accounting and how to handle it.
Implementing debt finance effectively requires a thorough understanding of the company’s financial position and borrowing needs.
Companies should assess their current financial health, evaluate their ability to meet debt obligations, and determine the most appropriate type of debt financing for their needs.
Final thoughts: Debt finance
Once debt financing is secured, effective management is crucial to maintaining financial stability.
This involves adhering to repayment schedules, monitoring cash flow, and ensuring compliance with any covenants or conditions attached to the debt.
Regular communication with lenders and proactive financial management can help mitigate risks and maintain a positive relationship with creditors.
Understanding what debt finance is and how it operates enables companies to make informed decisions about their financial strategies.
By carefully assessing their financial health, choosing the right type of debt, and managing obligations effectively, businesses can leverage debt financing to support growth and achieve their objectives while mitigating associated risks.
For other informative guides, take a look at our blog. If your business is struggling to settle a tax bill, it may be able to secure a time to pay (TTP) arrangement to repay debt to HMRC.
We are Accountants East London, experts offering affordable services – please don’t hesitate to contact us.
