What is debt financing?

Debt financing is crucial for most businesses at an early or in the near future.

It has been known for a very long time that in order to start a business you need capital as it is one of the most important ingredients in business preparation. It is important to note that it’s not only individuals that needs money for business operations but big organisations also needs capital for business or project financing.

Debt financing occurs when an organisation or firm raises money for working capital or financial operations by selling bonds, bills or notes to individuals and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise the principal and interest on the debt will be repaid. The other way to raise capital in the debt markets is to issue shares of stock in a public offering; this is called equity financing.

Therefore, they go through various ways to raise capital for their activities either through issuing shares of stocks in a public offering (equity offering) selling bills, bonds or notes to individuals or institutions that are interested in investment.

Individuals and institutions in return become creditors to the firm and in return will be repaid with principal and interest. An organisation can obtain capital in various ways. This can either be in form of Cash, Debt or a hybrid of the two.

Debt financing can be difficult to obtain, but for many companies, it provides funding at lower rates than equity financing, especially in cases of low interest rates. Another benefit of debt financing is that the interest on debt is tax deductible, which makes it better for the firms.

However, it is good to note that while adding too much debt increases the cost of capital of a firm, it therefore, reduces the present value of the firm.