When a company needs financing for working capital or expenditures, one option is Debt Financing, which means selling bonds, bills or notes to investors and institutions. This means that the company will issue debt which requires to be repaid with an interest. This type of financing is an option among others which are cash or a combination of both.
The money a company receives from Debt Financing is the amount of the investment loan which is referred to as the Principal, which can be obtained through banks and bond purchasers, Debt represents an obligation on the issuing entity and is the highest claim on it’s assets in case of bankruptcy unlike Equity financing; which is issuing shares (ownership) in the company and hence doesn’t need to be repaid but has a higher cost than Debt Financing because shareholders have claims on the company’s earnings while Debt provides lower cost of borrowing which is just the interest. The interest is tax deductible, but too much of debt issuing or Debt Financing can hurt the company’s present value as a result of high cost of capital.
Investors in debt varies in their concerns, one kind are concerned with principal protection while others are seeking returns in the form of the interest paid.
The rate of interest is determined by the creditworthiness of the issuer (borrower) and market rates, High interest rates imply low creditworthiness of the issuer which and high degree of risk and default, while high interest compensate the investor for the high risk taken, low interest rates on the other hand implies high degree of creditworthiness of the issuer (borrower) and low risk of default.
Some financial performance related rules referred to as Covenants are often required by the debt issuer (borrower) to adhere to them in order to gain recognition.
Debt Financing Measurement
Financial analysts are concerned about measuring financial strength of companies tend to measure the ratio of debt a company holds in relation to equity capital, and this could be done by calculating the Debt-to-Equity ratio which is simply the total debt divided by the total shareholders’ equity (get them from the balance sheet), low ratio is much more preferable than high one, where low ratio means a company finances it’s expenditures and working capital with more equity than debt, and vice versa.
CEO – GPI Global Partners Investments Ltd