Debt Financing: What it is, and Why Business Owners Use it

When it comes to scaling a business, there are several arrows in a CEO’s quiver. One of those is debt financing.

There are very strong reasons to consider debt financing over equity financing, even though the former comes with its share of risks (not the least of which is the risk of potential bankruptcy and asset seizure).

In this article, we'll delve into why companies opt for debt financing, exploring the benefits of maintaining ownership, the tax advantages of interest deductions, and the flexibility such financing offers. We'll also weigh these benefits against the risks, such as increased financial leverage and the potential impact on a company's business operations.

Key Highlights:

• Debt financing allows companies to raise capital while retaining full ownership and control
• Debt financing offers distinct advantages over equity financing, yet there are associated risks which must be carefully considered
• While debt financing offers flexibility and potential tax benefits, it also increases financial leverage which can negatively impact business performance and potentially lead to bankruptcy

What is Debt Financing?

Debt financing is a strategy companies use to raise funds by borrowing. This can involve securing loans from banks, issuing bonds to investors, or utilizing other forms of debt. The borrower then pays that loan back with interest.

One of the primary advantages of debt financing is the preservation of ownership. Unlike equity financing, debt financing allows company owners to raise capital without diluting shareholder equity.

Another major advantage is the interest paid on debt often reduces taxable income due to its tax-deductible nature.^[1] Of course, debt financing also increases a company's financial liability and can strain profitability and cash flow due the interest payments that debt financing entails.^[2]

What is the Difference Between Debt Financing and Equity Financing?

Choosing between debt and equity financing is a critical decision for companies looking to raise capital. Below are several key differences between the two strategies:

• Ownership and Control: Debt financing involves borrowing funds that must be repaid, typically with interest, and does not alter the company's ownership or control. In contrast, equity financing requires selling company shares and granting investors a stake (and potentially a say) in business decisions.
• Cost Comparison: Debt is often more affordable than equity in the long run, given that debt holders only need to be repaid their principal plus interest, in contrast to equity holders who own shares in the company and participate in any valuation appreciation.
• Financial Implications: Debt adds to the company's liabilities and necessitates regular interest payments. If not managed properly, debt can be detrimental to the overall health of the company. However, the interest payments on debt are tax-deductible, which can lower taxable income and provide some financial relief.^[3] Equity financing doesn’t affect liabilities, but it can dilute existing ownership and may result in dividends paid to shareholders.^[4]

The Benefits and Risks of Investing in Debt Financing

Debt financing can be thought of as a double-edged sword. On the one hand, debt is a relatively inexpensive form of capital, yet on the other, interest payments might put companies in a bind should they be unable to meet their repayment obligations.

Below are the inherent benefits of debt financing:

Consistent Cash Flow: Borrowers must pay interest–typically monthly or quarterly (though at times no interest is due until the debt fully matures). In such cases, debt investors will earn regular cash flow in the form of payments from the borrowers.
Protection in Case of Bankruptcy: Investors in secured loans (backed by assets), maintain a safety net in case of bankruptcy, as they can assume control of the assets and liquidate them in order to recoup some or all of their principal investment. Equity investors have no such protections in place. Read our article on the different types of collateral to learn more.
Refinancing Potential: Borrowers approaching maturity on their debt can seek to refinance their loans, extending the runway until a principal repayment is necessary. Often, this refinancing is issued by the original lenders, which means debt investors can experience ‘repeat business’ from the same customer.

Of course, debt financing also comes with its share of risks:

• Overleveraged Balance Sheet: Excess debt heightens financial risk and can cause liquidity challenges. When businesses take on a loan, ‘the clock is ticking.’ In other words, the business will have to repay that loan after a set period of time, which necessitates revenue generation (or a refinancing down the road).
• Macroeconomic Uncertainty: Market volatility can impact borrowing costs and the company's ability to service its debt. This can create unforeseen circumstances which impact management’s ability to meet their repayment obligations.
• Interest Rate Uncertainty: During times of rising interest rates, fixed rate loans are less attractive for investors (as the benchmark rate rises, the fixed return loses value in real terms). And during times of falling interest rates, floating rate loans become less attractive (these are loans that rise and fall in tandem with the benchmark rate).^[5] So investors should diversify their loan portfolios accordingly.

At Heron Finance, we take steps to mitigate the risks posed by debt financing. Our rigorous due diligence processes, coupled with our focus on geographic and sector-wide diversification, aim to weather-proof our investment portfolio against unforeseen economic shocks.

You can learn more about how we select our investments here.

If you’d like to invest in debt financing, click the button below to set up your Heron Finance account.