Why Do Companies Use Debt Financing? - Carofin - An Alternative Investment Marketplace Powered By Carolina Financial Group (2024)

The following outlines the major reasons why businesses may choose to use debt financing over issuing equity when capital is needed.

Businessesandother entitiescanfinance theirenterprisesbyissuing equity orusingdebt, such asborrowing funds throughloansor by issuingnotes.Unlike equity, debt has a specifiedinterest rateand a schedule of dates when interest is to be paid andalltheprincipalfully repaid.

Many fast-growing companies would prefertouse debt to support their growth, rather than equity, because it is,arguably,a less expensive form of financing(i.e.,the rate of growthof the business’sequity valueis greater than thedebt’sborrowingcost). But there muststillbesufficientoperating cash flow generated by the enterprise to “service” the debt’s interest and principal payment obligations,or therecouldbe severe consequences for the business,as noted below.

Reasons whycompanies mightelect touse debt rather thanequity financinginclude:

  • Aloan doesnotprovide an ownership stakeand,so,does not causedilutiontothe owners’ equitypositionin the business.
  • Debt can be a less expensive source of growth capital if the Company is growing at a high rate.
  • Leveraging the businessusingdebt is awayconsistentlytobuild equity value for shareholders as the debt principal is repaid.
  • Interest on debt is a deductible business expenses for tax purposes, making it an even more cost-effective form of financing.
  • Debt can be somewhat less complicated to arrange than equity financing and may not require shareholder approval.
  • There is a broad universe of lendersthatspecialize in various industries, stages of business and types of assets.
  • Once the debt is repaid, it’s gone. Equity remains outstanding unless repurchased by the Company,which typically requires the shareholder’s consent.

Debt can be used to finance a wide variety of business activities including working capital (to acquire inventory, for example), capital expenditures (such as to finance equipment purchases) and acquisitions of other companies, to name a few. The term or maturity of the indebtedness should generally match theperiodassociated with the assets being financed. For example, inventory, accounts receivable and other short-term assets are usually financed with short-term debt that is less than one year in maturity. Equipment loans are normally three years or longer, andmortgageloansfinancingreal propertyare typically 15 years orlonger sincethose assets have longer useful lives for the business.

From the borrower’s perspective, debt has a fixedcost, theinterestrate, butitrepresentsasignificant potentialthreat tothecompany’sexistence. Ifinterest and principalare notpaid as agreed,lenders canforeclose,possibly requiringthe business tocease operations andliquidateits assets.Issuing equity, on the other hand, results in sharingfuture profitswith investorsbutis lessthreatening to the future of the business ifprofitabilitybecomesimpaired.

Debt is senior inliquidation preferenceto equity when a company’sassets are sold,reducingthe amounts availableto equity investorsfromanyasset sales, forced or voluntary.Though not obliged to do so, lenders may agree to restructure a non-performing loan byagreeing toforebearwhichoftenextendsthematurity of the loan, possiblywiththeaccrualofinterestduetolenders,albeit normally at a higherinterestrate.

From the investors’perspective, debt investments are also known asfixed incomeinvestments sinceinterest and principal payments are scheduled and areanticipatedafter the loan ornote investment is made. Equity investments, on the other hand,produce varying levels of return depending on the profitability of the Issuerover time.

Why Do Companies Use Debt Financing? - Carofin - An Alternative Investment Marketplace Powered By Carolina Financial Group (2024)


Why do companies use debt financing? ›

Reasons why companies might elect to use debt rather than equity financing include: A loan does not provide an ownership stake and, so, does not cause dilution to the owners' equity position in the business. Debt can be a less expensive source of growth capital if the Company is growing at a high rate.

What is the difference between debt financing and equity financing Quizlet Everfi? ›

What is the difference between debt financing and equity financing? Equity financing involves selling shares of ownership in the company while debt financing does not.

Why would a firm use debt to finance a large project Quizlet? ›

The use of debt as a source of funds is desirable since the interest payments made by the firm on its debt are tax-deductible. Firms can claim their interest payments during the year as an expense and reduce their reported earnings and taxes; when firms use equity as a source of funds, they do not benefit like this.

What is a reason for corporations to use debt in capital financing CFI? ›

A key reason for corporations to use debt in capital financing is to lower the cost of capital. This occurs because debt financing typically has a lower cost compared to equity financing, primarily due to the tax-deductible nature of interest payments on debt.

What is the major advantage of debt financing? ›

A big advantage of debt financing is the ability to pay off high-cost debt, reducing monthly payments by hundreds or even thousands of dollars. Reducing your cost of capital boosts business cash flow.

How do companies use debt to leverage their financial returns? ›

When you borrow money, you can leverage that loan by hiring additional workers, expanding your facilities or producing more inventory. The revenue you generate from those activities can be used to both pay off the debt and to generate profit that your company can keep.

Why might a company choose debt financing rather than equity financing? ›

SHORT ANSWER: All else being equal, companies want the cheapest possible financing. Since Debt is almost always cheaper than Equity, Debt is almost always the answer.

What is the most important method of debt financing for corporations? ›

A loan is considered the most essential way of debt finance for companies. It is easily available finance that can be borrowed from any commercial banks or financial institutions in exchange for collateral security and the business is obliged to pay a constant interest for the principal loan amount.

What is a source for debt financing used by some companies? ›

Common sources of debt financing include business development companies (BDCs), private equity firms, individual investors, and asset managers.

What is the main disadvantage of debt financing? ›

The main disadvantage of debt financing is that interest must be paid to lenders, which means that the amount paid will exceed the amount borrowed.

What is the purpose of debt capital markets? ›

Definition. The debt capital markets (DCM) department acts as an intermediary between issuers of public or private debt and market investors. In simple terms, it helps governments and companies to borrow money in the form of tradeable securities at the best possible terms.

What is the main benefit of using debt in the capital structure? ›

Debt is one of the two main ways a company can raise money in the capital markets. Companies benefit from debt because of its tax advantages; interest payments made as a result of borrowing funds may be tax-deductible. Debt also allows a company or business to retain ownership, unlike equity.

Why do companies do debt offerings? ›

Debt provides an opportunity to extend your cash runway between raise rounds. If your burn rate leaves you without enough time and funds until more capital can be raised, debt is a worthwhile consideration. Working to increase sales and reduce expenses is also worthwhile, but results are not guaranteed.

Why use debt to acquire a company? ›

Acquiring companies that are seeking smaller amounts of funding and hope to obtain this funding more quickly will often pursue debt financing as opposed to equity funding. Businesses that want to retain control and remain local are also likely to seek debt-based acquisition financing.

Why do most companies use a mixture of debt and equity financing? ›

Creating a capital structure that includes a mix of equity and debt improves a company's financial strength. Equity is also long-term capital. Equity also does not need to be repaid by the company and shareholders have a longer time horizon to realize a return on their investment.

Why do companies use debt to equity ratio? ›

The debt-to-equity (D/E) ratio compares a company's total liabilities with its shareholder equity and can be used to assess the extent of its reliance on debt. D/E ratios vary by industry and are best used to compare direct competitors or to measure change in the company's reliance on debt over time.

Top Articles
Latest Posts
Article information

Author: Otha Schamberger

Last Updated:

Views: 5946

Rating: 4.4 / 5 (55 voted)

Reviews: 94% of readers found this page helpful

Author information

Name: Otha Schamberger

Birthday: 1999-08-15

Address: Suite 490 606 Hammes Ferry, Carterhaven, IL 62290

Phone: +8557035444877

Job: Forward IT Agent

Hobby: Fishing, Flying, Jewelry making, Digital arts, Sand art, Parkour, tabletop games

Introduction: My name is Otha Schamberger, I am a vast, good, healthy, cheerful, energetic, gorgeous, magnificent person who loves writing and wants to share my knowledge and understanding with you.