Debt Financing Definition:
When a company / firm / business raises fund that you get to maintain your business operations is known as debt financing. This fund is raised by offering debt instruments to individuals or investors. In return an organization or business give creditors a guarantee note stating to payback principal plus interest on the debt within a specified period of time.
It includes both unsecured and secured loans. Security includes a type of pledge / bond / asset as an assurance that loan will be paid with interest. In case of debtor getting defaulter on the repayment terms then the security is sold / surrendered to fulfill installment of the debt. Lenders mostly ask for security on the loans. In few case like brand or reputed goodwill, lender may give you loan on your name alone.
Debt finance is broadly divided in to three types of categories:
- Short Term (Secured / Unsecured) Loans – usually repaid within 6 – 12 months term period.
- Intermediate Term (Secured / Unsecured) Loans – usually repaid within 3 years term period.
- Long Term (Secured / Unsecured) Loans – usually repaid within 5 years term period.
Debt Financing Example:
Let us take an example of debt financing from a Coffee shop which is owned by Jeff. He has been doing business for a long time. Throughout the most recent couple of months, Dennis considers growing his business. Along these lines, he meets with a credit officer in the bank to talk about debt financing.
Jeff was given an offer by loan officer to gets INR 100,000 for a long time at 8.75% interest on principal. This concludes that Jeff has to pay INR 15,039 every year till 10 years. To secure the credit, the loan officer requests that Jeff should provide the coffee shop asset papers as guarantee in case if Jeff fails to payback the amount with interest.
Debt Financing is a costly method for raising cash. On the fact that the organization include a third party in the condition and structure a high credit extension deliberately to back its operations. Then again, it’s the best way to leverage your business to raise fund without utilizing own funds.
Source of Debt Financing:
1. Bank Loans: Bank loans are the most widely recognized method of debt finance for an organization or a business. Organizations raise a fund from commercial banks by keeping some security as a guarantee against the bank loan. Bank loans are for fixed period and business needs to pay installments regularly. This can be one of the better sources of debt financing for large companies. Bank provides three types of loans short-term loan, long-term loan, intermediate loan according to the requirements of the business.
2. Trade Credit: A course of action in which the business can buy the products now and pay them later is called as Trade Credit. This is one of the sources of debt financing for shorter time period. This is one of the best sources of debt financing for startup companies as they can’t stand to get bank loans by providing security as guarantee.
3. Purchasing on Installments: Buying goods on installments is one of another source of debt financing. Buying on installments involves buying assets benefit as well as making installment in pre-decided installments. The purchaser needs to mortgage his assets until the point when full settlements of payments are made. In case when a business account is operating at highest credit rating. Business might not need to mortgage any assets. This facility of installment purchases is given by Banks, Commercial Lenders, or any Financial Institutions or investors to the business.
4. Asset Lenders: Those lenders who fund organizations by means of loan to the business for buying any assets are known as asset lenders or asset specialized lenders. The business consequently needs to mortgage its assets, for example: accounts receivables, stocks, inventories, etc. This is one of important source of debt financing for large companies. This option of debt finance is valuable for organizations that have large amount of account receivables, stock, land, etc. that can be mortgage to lenders.
5. Bonds: Those business or companies which are well established and requires fund for growth for them Bonds are the best source of debt financing. The business or companies can raise finances by selling their own bonds to open market which can be purchased by different buyers and sharing benefits on the activities for which bonds are issued. For examples: a company can issue a bonds as “Infrastructure Development Bonds” and a state or country can issue a bonds like “Road Transportation Development Bonds” with better interest rates than the banks saving or fixed deposit rates to attract buyers or investors.
6. Insurance Agencies: Insurance agencies or companies are another major source of debt financing to small business or startup companies. They normally offer 2 types of loans i.e. Policy Loan or Mortgage Loan. A policy loan depends on the measure of cash that is paid as a premium on the protection policy. On the other note, a mortgage loan can be opted by mortgaging any assets of the organization. Then again, arrangement credit depends on the measure of cash that is paid as a premium on the protection approach.
These are few debt financing sources. There are numerous more debt financing instruments are accessible and available in the market. The business can choose any prospects after figuring out which source suits them the best.