What is Debt Financing?

Debt financing is a way for companies to raise money. They do this by selling debt instruments to investors. These are fixed-income products, such as bonds, bills, or notes. 

When a company issues debt, it promises to repay the principal amount plus annual interest payments (known as coupon payments).

How does debt financing differ from equity financing?

Debt financing raises money without giving away a stake in the company, but with an obligation to pay back the debt. It can be raised from sources such as banks, loans, credit unions, state and government programs, or even family and friends.

Equity financing means raising money from investors, typically by selling shares. This gives the investors a stake in the company, but no guarantee that they’ll get a return on their investment.

What are the pros and cons of debt financing?

Debt financing has a number of advantages and disadvantages for businesses.

The main advantages are that it:

  • Doesn’t affect the ownership of the business
  • Doesn’t give the lender a claim on a percentage of future profits
  • Creates predictable debt obligations that can be planned for
  • Allows tax deductions for interest on debt
  • Is often less costly than equity financing, as it’s less risky for the lender

The main drawbacks are that it:

  • Can be risky for businesses with variable or vulnerable cash flows
  • Requires debt repayments regardless of revenue
  • Creates a higher debt-equity (D/E) ratio that can increase the company’s financial risk
  • May require the owner(s) of the company to personally guarantee the debt
  • Could result in the loss of company assets

What is the debt/equity (D/E) ratio?

The debt/equity ratio, or D/E ratio, is a measure of how much the company is funded through debt vs. shareholder equity. If the D/E ratio is below 1.0, that means the company is funded more through equity than debt. If it is above 1.0, that means it’s funded more through debt than equity.

A high D/E ratio usually suggests that a company is in a risky position: it has aggressively financed its growth using debt.

What’s considered “high” varies between different industries. Generally, a ratio of 2.0 or higher is seen as risky.