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What is Debt Finance?

Debt finance refers to borrowing funds that must be repaid over time, typically with interest. It's a common way for businesses and individuals to raise capital without relinquishing ownership. Loans, bonds, and credit lines are classic examples. Understanding the nuances of debt finance can empower you to make informed financial decisions. What impact could it have on your financial strategy?
Geri Terzo
Geri Terzo

Debt finance is the practice of issuing bonds in the capital markets by corporations. It is an alternative to equity finance, which is the issuance of stock in financial markets. Debt finance may be selected over equity because the fees associated with bonds, including investment banking costs, are less than those tied to equity. The purpose of issuing debt is to raise capital for a corporate event, such as a project, expansion, or product development.

When a company turns to debt finance, it issues corporate bonds into the capital markets. Investors who become bondholders or debt holders are making loans to the company, and in return, the lenders receive promised interest and principal payments, known as coupons, over the course of the loan. When the term of the loan reaches its maturity date, investors are paid the face value of the bond. The average life of a bond is between seven and 30 years. A benefit to debt issuance is that the payouts that are made to bondholders are considered tax deductible, and therefore may be treated as an expense on a company's income statement.

Businessman with a briefcase
Businessman with a briefcase

Investors who purchase corporate debt are taking on less risk than stockholders. Unlike equity holders, debt holders can rely on consistent income since a company is obligated to pay them regular principal and interest distributions. Stockholders may also receive distributions in the form of dividends, although bondholders are the first to be paid from cash reserves. Additionally, in the event that a company files for bankruptcy, debt holders receive higher priority to be repaid over equity holders, although bondholders are second in line to the company's creditors, including its suppliers.

There are also risks and disadvantages associated with debt finance. In the event of a corporate bankruptcy, a company's assets are at risk of being taken over by its largest bondholders if it misses any scheduled interest or principal payments. For instance, if a company does not comply with the terms of the loan that was issued as a part of debt finance, bondholders can trigger a liquidation of the company's assets in order to be paid. A company that is active in debt finance should exhibit discipline with its cash reserves and also must outline anticipated profits over the period of the loans. There is less flexibility with future cash flow for a company active in debt finance versus equity financing because of the payment distribution obligations.

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