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Meaning of Debt Financing
Business is in continuous need of funds for working capital needs or for incurring capital expenditures. In such scenarios, when the business borrows money from the lenders at a fixed or floating rate of interest and for a fixed span of time, it is termed as debt financing. The sources of debt financing for a company include banks, credit union, etc.
Let us learn further about the sources of debt financing.
Sources / Types of Debt Financing
Loans are the most common and popular mode of debt finance for a company. Businesses borrow money from commercial lenders like banks by keeping some collateral security against the loan. Loans from banks and other commercial lenders are for a fixed period and business needs to pay regular interest for it. The loans can be for short, intermediate or long-term depending upon the financial requirements of the business.
Trade credit is an arrangement in which the business can purchase the goods now and pay for them later. This way the business can avail debt financing for short term. Trade credit is a good mode of finance for startups as they cannot afford to obtain loans of the higher amount by placing a collateral society.
Purchasing the capital goods on installment is another type of debt financing. Installment purchase comprises of buying an asset and making payment in pre-determined installments. The buyer has to mortgage its asset until full payment of installment is made. A business that has higher credit rating may not have to mortgage any asset. Banks and finance companies provide the facility of installment purchase to the business.
Asset Based Lenders
Asset-based lenders are those finance companies that lend money to the business for purchasing the assets. The business in return has to pledge its assets like inventory, accounts receivables, etc. This type of debt financing is very useful for businesses that have higher inventory, account receivables, real estate or any other asset that can be pledged.
Bonds are a source of debt capital for businesses that are well established and need funds for long-term growth of the business. The company can raise funds by selling bonds to different buyers and sharing profits on the projects for which bonds are issued.
Factor purchases the accounts receivables of the companies. In factoring agreement, the business gets the timely flow of money and does not have to wait for the customers to pay them. In return, the business has to pay the factor a certain fee or commission. Factoring is of two types i.e. recourse factoring and non-recourse factoring. Based on the need and requirement, the business can opt any of the suitable financing facility.
Insurance companies act as a major source of finance for small companies. They provide two types of loans to the businesses namely; mortgage loan and policy loan. A mortgage loan can be availed by mortgaging any asset of the company. On the other hand, policy loan is based on the amount of money that is paid in the form of a premium on the insurance policy.
These are few debt financing sources. Many more debt-financing instruments are available in the market. The business can select and avail these services after looking at their prospects and determining which source suits them the best.
Debt financing is the second most popular source of financing for businesses, the first being equity financing. Debt financing enables the business to not only meet its working capital requirements but also expand its business. The business needs funds at regular intervals and the entire monetary requirement cannot be met with equity financing after a certain point of time. In such scenarios, debt financing acts as a helping hand to fulfill the monetary needs of the business. Going forward the sources and need for debt financing will increase rapidly because the new startups are growing and the current players will need additional funds to fight competition.1–3