Definition: When a company borrows money to be paid back at a future date with interest it is known as debt financing. It could be in the form of a secured as well as an unsecured loan. A firm takes up a loan to either finance a working capital or an acquisition.
Description: Debt means the amount of money which needs to be repaid back and financing means providing funds to be used in business activities. An important feature in debt financing is the fact that you are not losing ownership in the company.
Debt financing is a time-bound activity where the borrower needs to repay the loan along with interest at the end of the agreed period. The payments could be made monthly, half yearly, or towards the end of the loan tenure.
Another important feature in debt financing is that the loan is secured or collateralized with the assets of the company taking the loan. This is usually part of the secured loan. If the loan is unsecured, the line of credit is usually less.
If a company needs a big loan then debt financing is used, where the owner of the company attaches some of the firm’s asset and based on the valuation of those assets, loan is given.
Let’s understand debt financing with the help of an example. If a company requires a loan of Rs 10 crore, it can raise the capital by selling bonds or notes to institutional investors.
Debt financing is an expensive way of raising funds, because the company has to involve an investment banker who will structure big loans in a systematic way. It is a viable option when interest costs are low and the returns are better.
A company undergoes debt financing because they don’t have to put their own capital. But too much debt is also risky and thus, companies have to decide a level (debt to equity ratio) which they are comfortable with.