Debt financing is a situation that occurs when a firm raise money for capital expenditure or working capital through selling its bonds, notes or bills to institutional investors or individuals. The individuals and institutions here become the creditors for lending money to the firm. In return, it gets a contract on repayment of the debt with principal and the interest. One other way to raise capital in debt market is through issuing shares of stock in public offering. It is also known as equity financing. Debt financing is sometimes difficult to obtain. However, it provides the companies with funding solutions at lower rates.
Interest Rates Pattern
Some investors in debt financing are interested in only principal protection. You will also find others that want their returns in form of interest. Here, the rate of interest is determined by creditworthiness or borrower and also by market mechanisms. When the rates are higher, it signifies greater extent of default and consequently much greater risks involved. On the opposite side of high-risk borrower is the high-risk investment. Moreover, a borrower in debt financing must also abide by the rules and regulations for financial performance. These rules are referred to as covenants. When the risk is higher due to high-interest rates, the compensation on part of borrower also gets high.
Measuring Debt Financing
Analysts will use a certain formula to compare and measure the financing of a company done through debt financing. The ratio that is used is known as debt-to-equity ratio. The total debt and the total equity for stakeholders are taken into account while calculating the ratio. You can take help of a professional to do so or click here to know more about the process and how it is done. You can hire outsourcing companies to take a look at your financial assets and help you decide about debt financing for your company.
About Debt Ratio
As a general rule, a low debt to equity ratio is preferred to a higher one as more the ratio; more is the potential risk for the borrower. There are also some industries in the market that have higher tolerance towards debt than others. You will find both equity and debt for your company on the balance sheet at the end of a financial year. Make sure you are seeking continuous guidance from a professional to understand the balance sheet and do not miss out on points that might increase your risk quotient later in future selling on company bonds and bills.
Variations In Ratio
Debt ratios vary greatly across industries. You will find that capital-intensive business in industries like pipelines and utilities have much higher debt ratios that others like technology. A debt ratio of thirty percent for a company with better financial situation is better than ones that are not. Also, thirty percent debt ratio may be too high for a company that has volatile cash flow taking minimal debts. Although, a debt of forty percent for industry like utility is much less as cash flow here is stable, and high ratio of debt is a rule.