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What is Debt Financing?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 31 August 2016
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Debt financing is a means of raising funds to generate working capital that is used to pay for projects or endeavors that the issuer of the debt wishes to undertake. The issuer may choose to issue bonds, promissory notes or other debt instruments as a means of financing the debt associated with the project. In return for purchasing the notes or bonds, the investor is provided with some type of return above and beyond the original amount of purchase.

Debt financing is very different from equity financing. With equity financing, revenue is generated by issuing shares of stock at a public offering. The shares remain active from the point of issue and will continue to generate returns for investors as long as the shares are held. By contrast, debt financing involves the use of debt instruments that are anticipated to be repaid in full within a given time frame.

With debt financing, the investor anticipates earning a return in the form of interest for a specified period of time. At the end of the life of a bond or note, the investor receives the full face value of the bond, including any interest that may have accrued. In some cases, bonds or notes may be structured to allow for periodic interest payments to investors throughout the life of the debt instrument.

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For the issuer of the bonds or notes, debt financing is a great way to raise needed capital in a short period of time. Since it does not involve the issuing of shares of stock, there is a clear start and end date in mind for the debt. It is possible to project the amount of interest that will be repaid during the life of the bond and thus have a good idea of how to meet those obligations without causing undue hardship. Selling bonds is a common way of funding special projects, and is utilized by municipalities as well as many corporations.

Investors also benefit from debt financing. Since the bonds and notes are often set up with either a fixed rate of interest or a variable rate with a guarantee of a minimum interest rate, it is possible to project the return on the investment over the life of the bond. There is relatively little risk with this type of debt financing, so the investor does not have to be concerned about losing money on the deal. While the return may be somewhat modest, it is reliable. The low risk factor makes entering into a debt financing strategy very attractive for conservative investors.

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Mammmood
Post 4

America needs to declare a moratorium on its debt. We’re drowning in it. I don’t see a way out. Maybe we’ll be bought out—by China!

allenJo
Post 3

@David09 - I’ve been there too. What’s interesting in these companies is to listen to the quarterly conference calls. At our place the CEO did a whole lot of spinning when asked by analysts what he was going to do when the money ran out. He simply said that they would grow their revenue to the point that it would never happen. His answer didn’t exactly give me the “warm and fuzzies.” A year later they filed for Chapter 11.

David09
Post 2

@nony - I know what you mean. I worked at a company where they filed bankruptcy twice before finally being bought out. It was a publicly traded corporation so we saw the earnings figures. They told us how much cash they had on hand and how much they owed on their existing debt loans. It wasn’t hard to figure out, based on those numbers, and the earnings figures (which weren’t that good obviously) when the corporation was going to “hit the wall” financially and declare bankruptcy or a buyout.

nony
Post 1

Large corporations use debt loans to get their businesses going. Debt financing is simply the only option they have—especially for corporations that rely on big infrastructure spending. The problem happens when they don’t bring in enough revenue to pay down the debt. They have limited cash flow and are struggling to meet their payroll and other expenses in addition to meeting their debt service agreements.

When this happens investors get nervous. Believe me—investors watch the cash flow, how much debt is being serviced, and how quickly the company is paying it down. Eventually the company will either increase its revenue to the point that they can pay their notes or file bankruptcy.

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