Debt financing means borrowing funds or making investments from external sources. Large companies and organizations are not able to run all their affairs from their own capital, so it is normal for them to take out loans. The most common example of this type of financing is the loans taken from banks. The size of the loan must be repaid in agreed installments together with interest at a specific interest rate.
Benefits of debt financing:
The following are the benefits of debt financing:
(i) Expansion area: Debt financing enables companies to expand their activities. New branches can be opened in other cities and countries. New business areas can be adopted to increase revenue. The easy availability of credit encourages the entrepreneur to take new risks and float new products. It also enables businessmen to increase the scope of their activities and upgrade their products in a timely manner.
(ii) Research and development: Debt financing allows the process of research and development. Loans from banks can be used to accelerate R&D activities. The company’s earnings potential increases as the hard research products flow into the market. The new innovation, in addition to increasing the companies’ reputation, also reduces production costs.
(iii) High Profit: Due to business expansion and use of new techniques, business revenue and profits are also growing. Huge revenue means that there will be room for further expansion of the business. Higher profits can also be used to repay the bank loans. This increases the company’s solvency.
(iv) Light working capital: Debt financing helps to maintain sufficient working capital in the company. It also allows for easy payments to be made on a regular basis.
(v) Resuscitation of sick units: Debt financing can be used to provide respite to the sick industrial units. The organization’s loans can be restructured and new credit can be taken out for such units so that they can start their production. In addition to providing funding, proper monitoring and guidance should also be provided. All of this will rehabilitate the sick units and can help them become successful and profitable units.
(v) Savings from insolvency: Debt financing can be used to save the business from insolvency. If a significant payment is to be made and there are not enough equity funds, a loan can be taken to make payments and to save the company from insolvency.
(vi) Tax advantage: As the interest fee is deducted from the net income before the tax rate is applied, it leads to lower tax liability.
Disadvantages of debt financing:
The following are the disadvantages of debt financing:
(i) Interest payments: Very large amount out of the company’s net profit must be paid due to interest on borrowed capital.
(ii) Depression: If a business falls into depression and losses occur, paying interest can become a major problem due to insufficient funds.
(iii) Suit Against Business: Creditor may sue companies if the company does not make payments as agreed.
(iv) Seizure of collateral: If the company does not pay interest on the principal amount of the loan, the bank may seize the collateral or the mortgaged property.
(v) Risky investment: If a company is already running on the huge borrowed capital, further investment in a company becomes risky. This risk deters investors. Banks are also reluctant to provide loans to such businesses that are already under debt burden.