Debt Financing

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What is 'Debt Financing'

Debt financing occurs when a firm raises money for working capital or capital expenditures 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.

BREAKING DOWN 'Debt Financing'

When a company needs money, it can take three routes to obtain financing: cash, debt or some hybrid of the two. Equity represents an ownership stake in the company. It gives the shareholder a claim on future earnings, but it does not need to be paid back. If the company goes bankrupt, equity holders are the last in line to receive money. The first investors in line are the lenders. These are the investors that provide the company with debt financing. The amount of the investment loan, referred to as the principal, must be paid back. Companies can obtain debt financing through banks and bondholders.

Debt financing can be difficult to obtain, but for many companies, it provides funding at lower rates than equity financing, especially in periods of historically low interest rates. Another perk to debt financing is the interest on debt is tax deductible. Still, adding too much debt can increase the cost of capital, which reduces the present value of the company.

Interest Rates on Debt Financing

Some investors in debt are only interested in principal protection, while others want a return in the form of interest. The rate of interest is determined by market rates and the creditworthiness of the borrower. Higher rates of interest imply a greater degree of default and therefore a higher level of risk. Higher interest rates help to compensate the borrower for the increased risk. On the other side of a high-yield investment is a high-risk borrower. In addition to paying interest, debt financing often requires the borrower to adhere to certain rules regarding financial performance. These rules are referred to as covenants.

Measuring Debt Financing

One metric analysts use to measure and compare how much of a company's capital is being financed with debt financing is the debt-to-equity (D/E) ratio. For example, if total debt is $2 billion and total stockholders' equity is $10 billion, the D/E ratio is one to five, or 20%. This means for every $1 of debt financing, there is $5 of equity. In general, a low D/E ratio is preferable to a high one, though certain industries have a higher tolerance for debt than others. Both debt and equity can be found on the balance sheet.

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