Essentially, debt financing means borrowing money from banks, other financial institutions, or companies to maintain current business activities or implement investment projects. Debt financing takes various forms depending on the sources and schemes for raising funds, the timing and method of debt repayment, the availability of collateral, etc.
Pros of Debt Financing Projects
The significant advantage of this approach is preserving control over the company. Unlike equity financing, a loan does not transfer part of the business to the lender as shares.
The pros of debt financing include the following
- Using credit for almost any business purpose
- Reduced tax pressure by accounting for interest as a company expense
- Minimal interference of creditors in the current activities of the business
- Simplified action for obtaining funding
- Flexible terms of debt repayment
In this condition, the ownership remains in the hands of the previous owners, so creditors can neither affect the decisions of the company’s management nor receive any profit other than the percentage and commissions established by the loan agreement.
Corporate control is mainly necessary for companies that pursue an aggressive business strategy. It is of fundamental importance to some entrepreneurs who seek to maintain independence above all else. For such companies, the loss of part of the assets in the event of debt default may be considered less of a problem than the loss of independence and function of the profits.
If debt financing of investment projects is accomplished with accurate planning and professional legal support, the risk of losing assets for the borrower is minimal.
Secondly, the advantage of this type of financing may be tax optimization. Interest payments can be treated as company expenses, not subject to taxation. Therefore, professionally arranged plus properly executed debt financing can reduce the borrower’s tax liability.
Finally, the continuous repayment of debt increases the credit rating of the borrowing company, which dramatically simplifies the business’s access to debt financing and increases the company’s financial stability. Thus, it will be possible to attract loans on more favorable terms at a lower percentage while implementing subsequent capital-intensive projects.
Cons of Debt Financing Projects
If we talk about the opposing sides of this type of financing, the significant disadvantage is the highest cost of borrowed funds.
The company is forced to pay the principal amount of the loan and interest, commissions, insurance, and other expenses depending on the particular contract.
When appearing as financial liabilities in the borrower’s periodic reports, loans become a severe financial burden for a business for many years and limit its commercial activities. Permanent payments over a long period (for large investment projects, the loan term reaches 15 years or more) can warn businesses since the market, economic, and political realities for an extended period are difficult to predict.
The complexity of the process of attracting borrowed funds is another problem.
Obtaining a long-term loan, exclusively when it comes to vast amounts of about 10 million euros or more, is accompanied by a lengthy and comprehensive verification of the applicant by the bank.
In addition to preparing an application and a package of official documents (including financial statements), borrowing companies are often required to provide loan security. Real estate (factories, commercial and residential premises, land plots) and movable property (commodity stocks, fuel, equipment, building materials) can be collateral. Financial obligations (crediting secured by receivables) also serve as collateral.
In the event of default under the loan agreement, the creditor may sell the debtor’s pledged assets and reimburse the cost of the loan obligation, including interest.
The possibility of losing part of the corporate assets represents a long-term risk for the borrower. Banks resort to guaranteed loans in cases where the applicant’s solvency is doubtful and the company is not ready to provide sufficient assets as collateral. Secured loans can be announced under the official guarantee of government agencies, international institutions, large companies, or other reputable partners.
Getting large loans to finance investment projects can be extremely difficult for young companies that do not have a good credit rating or a long operating history. Highly indebted companies are viewed by potential investors as risky, limiting their options.
In conclusion, it is worth noting that debt obligations can negatively affect the growth of a business since a significant part of the profit is spent on repaying loans. In the long term, this situation can affect business prospects and survival since the problem in the globalized market is unpredictable and, in general, highly volatile.
In connection with the above, many companies must use several sources of project financing, including equity financing.
To a certain extent, the issue of shares helps balance the capital sources, making the company more stable and viable.
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