Debt financing: definition, types, advantages and disadvantages

Definition: what is debt financing?

Definition: what is debt financing?

Debt financing is financing through debt capital. A lender leaves money to a company for a limited period of time. The company undertakes to pay interest on this sum and to repay the amount on a previously agreed date. Debt financing is usually used for investments or to meet a company’s short-term liquidity needs.

What is the difference between self-financing and debt financing?

In contrast to self-financing, the lender of external financing is not liable for the company’s activities. Depending on the legal form of the company, equity investors are fully liable with their assets, only in part or in a limited form in the amount of their contribution. In the event of bankruptcy, the lender of a debt financing is entitled to the repayment of his loan before other capital providers or the owners themselves. In contrast to equity providers, lenders do not participate in a company’s profit and loss.

While debt remains in the company for a limited period of time, equity usually remains long-term. The equity capital received does not have to be repaid.

In contrast to equity investors, lenders have no say in corporate decisions.

What types of debt financing are there?

What types of debt financing are there?

A basic distinction is made between short-term and medium to long-term forms of debt financing. There are also special forms – so-called loan substitutes – that are used for financing instead of a normal loan. And last but not least, there are mixed forms between equity and debt financing. Below we show you examples of debt financing.

  • Short-term debt: trade loans

    Commercial loans include customer loans, which come about, for example, through down payments or partial payments, but also supplier loans that arise when suppliers e.g. B. Grant generous payment terms.

  • Short-term bank loans for debt financing

    Short-term bank loans include overdrafts, so-called overdrafts or overdrafts.

    There are also bills of exchange. This means that a loan is secured by a bill of exchange. A bill of exchange is a security that instructs the issuer to transfer money to the recipient of the bill of exchange. Bills of exchange are rarely used today because they are very complex to handle.

    The Lombard loan is also a short-term bank loan: It is a loan that is secured by pledging securities, bank deposits or movable property.

  • Short-term debt financing: credit bonds

    Loans: With loans, banks do not provide money, only their creditworthiness. There are two types of credit bonds:

    • Acceptance credit: With an acceptance credit, a bank accepts bills of exchange issued by the customer. The credit institution is then obliged to honor the bill of exchange with a third party who has the acceptance. Again, the obligation is independent of whether the borrower is covering the bill.
    • Guarantee credit: In the case of guarantee credit, a credit institution guarantees against certain liabilities for a fee.
  • Medium to long-term debt financing: promissory note loans

    Promissory note loans are only granted to borrowers with very good credit ratings. The loan is similar to a bond – however, the promissory notes are not traded on the stock exchange, but are typically transferred from credit institutions to large investors such as insurance companies, pension funds or social insurance institutions.

  • Medium to long-term debt financing: bonds

    A bond is a security that grants the creditor the right to repay and to pay agreed interest.

  • Medium to long-term debt financing: employee participation

    The idea behind employee participation is as follows: First, employees put their capital into the company in which they work. Later they will be involved in the financial success. Ideally, employees feel much more connected to their employer and are more motivated to do their best. If you as an entrepreneur want to involve your employees, you can do this in the form of shares or company shares. This form of participation is still very rare in Germany. It already exists in many companies in the United States.

  • Medium to long-term debt financing: foreign trade loans

    Foreign trade credits are intended to finance foreign trade and are granted to importers and exporters. Lenders are credit institutions, in this case especially the Kreditanstalt für Wiederaufbau (KfW) and the Export Credit Company (AKA).

  • Long-term bank loans for debt financing

    This means company loans that have a term of at least 4-5 years.

  • Special form of external financing: leasing

    Companies traditionally use leasing to use vehicles or technical equipment for monthly installments. This is often cheaper than buying the property yourself. Leasing also makes sense in other contexts. For example, companies can lease their own real estate. This process is called sale-and-lease-back. The company sells its properties to a leasing company and then leases them back. On the one hand, entrepreneurs can save taxes because leasing costs can be deducted from tax as operating expenses. On the other hand, companies can significantly improve their liquidity in this way, since they do not have to tie up any capital in the property. This method also offers long-term planning security for the company, since the monthly charge is determined when the leasing contract is concluded.

  • Special form of external financing: factoring

    In factoring, a company sells an outstanding claim that it has against a customer to a factoring company before this claim becomes due. This way the company gets its money earlier. Of course, it also has to pay a certain percentage of the outstanding receivable to the factoring company and therefore does not receive the full amount that the customer owes the company.

  • Special form of debt financing: asset-backed securities

    Translated, this term means “asset-backed securities”. This means that rights from claims or other payment claims are represented in the form of tradable securities. In this way, companies refinance themselves via the capital market and obtain debt in the short term.

  • Mixed form between internal and external financing: mezzanine

    Mezzanine capital is a mixture of equity and debt, because equity is added to a company from the balance sheet, but the lenders are not granted voting rights or any other form of influence. Mezzanine capital, for example in the form of profit participation rights or silent participations, is considered to be similar to equity. However, it can also be granted in the form of subordinated loans or shareholder loans and then has more of the character of outside capital. It must then also be recognized in the balance sheet as debt.

What are the advantages and disadvantages of debt financing?

What are the advantages and disadvantages of debt financing?

The debt financing options presented above have both advantages and disadvantages for companies.

Advantages of debt financing

  • Tax benefits: Since the company has to pay interest on the loan capital, it can record this as an expense. This in turn reduces the tax burden that the company has to pay.
  • Self-determination: Lenders have no say in corporate governance (the only exception – as described above – are certain forms of mezzanine capital)
  • No participation: Lenders are not involved in the company’s profit (but also not in the loss). You only get back the capital you invested, including interest.

The advantage of the leverage effect

If you wonder how leverage affects the return on equity, the leverage effect comes into play. It means that entrepreneurs can increase their return on equity by using debt instead of equity.

An example: An entrepreneur needs $ 200,000 to invest in a factory. It assumes that it will generate a return of 10% per year with this factory in the future. She pays $ 100,000 from her equity. The other $ 100,000 is borrowed from the bank at an interest rate of 5%. The entrepreneur’s plan works and she actually generates a 10% return per year (i.e. $ 20,000). Your return on equity is 20%.

Because: return on equity = profit: used equity

20,000: 100,000 = 0.20 (this corresponds to 20%)

If the entrepreneur had financed the entire investment of $ 200,000 from her equity, her return on equity would only be 10%.

Because: 20,000: 200,000 = 0.10 (this corresponds to 10%)

The leverage effect shows why debt financing can be cheaper than self-financing. The use of outside capital “leverages” the entrepreneur’s return on equity upwards. That sounds good – and it is. However, the leverage effect cannot be used for an unlimited number of investments at the same time, because

  • Entrepreneurs cannot take out an unlimited number of loans
  • the more loans entrepreneurs take out, the higher the interest they have to pay. As a result, the leverage effect turns negative: The interest on the loans becomes so high that it consumes the return on equity or is even higher than the return on equity.

Disadvantages of debt financing

  • Interest costs: Depending on the creditworthiness of the company and the current market situation, the interest payments for the borrowed capital may be high.
  • Risks: If a company borrows from multiple sources, it must also pay interest and repayments to several lenders. If the managing directors overestimate the economic situation of their company, or if the business slumps for any reason, this can lead to payment bottlenecks and one or more donors can no longer be served. This in turn can lead to overindebtedness.
  • Time pressure: Companies agree on a fixed point in time with the lender at which the lender gets their capital back. Depending on the economic situation the company is in at the time, this money may be missing.

When does it make sense to use external financing – and when does self-financing?

Both types of financing have their advantages and disadvantages. A general answer to this question is also difficult because the decision depends, among other things, on the following criteria:

  • How big is the company?
  • What is the corporate structure like?
  • What industry is the company in?

Basically, it is always a matter of finding the right ratio between debt financing and self-financing for every company.

At the beginning, entrepreneurs should answer the following questions for themselves before deciding on a variant:

  • Do I want to lower my tax burden? In this case, it can make sense to borrow part of the money – for an investment, for example – through external financing. In this way, the outside capital helps to minimize the tax burden.
  • Do I want to provide my company with long-term, solid capital? In this case, entrepreneurs should focus as much as possible on equity financing. In contrast to lenders, equity investors usually have a greater interest in the company remaining in the long term.

How do I approach the ideal amount of my debt financing?

If debt financing is fundamentally possible, the above formula for the leverage effect (return on equity = profit: equity invested) helps when deciding on the amount.

By using different amounts of equity in the formula, you can quickly find out which ratio of equity to debt is reasonable. Your bank will then help you with the exact calculation. Also, find out about the interest you would pay under the debt financing model you chose and make sure that this interest does not erode the return on equity.

What does internal financing mean and what is external financing?

The terms internal and external financing often appear in connection with the topic of external financing.

Internal financing: Internal financing is financing through funds that are already in the operational cycle.

External financing: External financing, on the other hand, is financing through funds provided by external capital providers.

In which cases does external financing not count as external financing?

The term external finance is often equated with the term external finance, although the two terms do not always match. Fundamentally, external financing is funds that are provided by external capital providers and not from the proceeds of the company itself.

Classic examples of debt financing that do not count as external financing are the following:

  • Provisions on a company’s balance sheet. The reason why provisions are shown as external financing in the balance sheet can be explained as follows: They represent possible claims “from outside” on the company. At the same time, however, they are instruments of internal financing because they can be traced back to internal reasons. In other words, provisions are external financing that is not external financing at the same time.
  • Financing from depreciation. Depreciation is also considered to be outside financing, although no external capital is added.
  • Financing through rationalization or restructuring. Rationalizations or restructurings are also shown in the balance sheet as debt capital, although their origin can be traced back to internal processes.

How can start-ups be supported by external financing?

Start-ups in particular often have little equity and often find it difficult to obtain common external financing – such as bank loans. Credit institutions often do not trust them enough. As a start-up aid, there are therefore special programs for business start-ups, such as grants, low-interest start-up loans, but also guarantees or participations.

However, many of these programs are not used as actively as the initiators thought. Founders complain that the application is often very bureaucratic and therefore they shy away from such offers. In addition, due to the very different programs that exist in this regard, it is often difficult to get an overview of all the options.