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Debt Financing: Definition, Types, Advantages & Disadvantages

Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll explain debt financing. You'll learn about the process of obtaining a loan and selling bonds. We'll also discuss the advantages and disadvantages of each type of debt financing.

What Is Debt Financing?

Jimmy Yums Donuts have been in business for 10 years. Everyone loves their hot, fresh from the oven donuts, and every morning, the drive-thru line is wrapped around the corner and down the street. The city officials where Jimmy Yums Donuts are located call a meeting to discuss the traffic and safety concerns in the drive-thru. They tell Jimmy that while they are grateful for his business, which has drawn national attention, he must do something about the traffic in the drive-thru.

Jimmy meets with the loan officer at Bank and Trust and tells the loan officer he's interested in expanding his business. He's thinking about adding another drive-thru lane to ease traffic and increase efficiency. He also wants to remodel the restaurant to encourage people to come inside.

The loan officer tells Jimmy he has two options: debt and equity financing. Equity financing allows him to sell stock to the public, which will be difficult for Jimmy's business since it requires a lot of documentation and money. Another option is getting a loan from the bank or selling bonds which are considered debt financing.

Debt financing is a promise to pay back a borrowed amount in the future with interest. Interest is considered the cost of loaning money. For the rest of this lesson, we'll explain debt financing and discuss the advantages and disadvantages.

Debt Financing With Loans

Loans are considered debt financing because a business incurs a liability or obligation in obtaining the loan. The loan is shown on the balance sheet in the liabilities section.

When a business wants to invest in a new product, add another location, or need help in paying their operating expenses, they can go to a bank and apply for a loan. The bank is considered a creditor and the business is the debtor.

Loans must be repaid, usually monthly over a specific period of time. The payments have two parts: principal and interest. Principal is the amount borrowed, while interest is what a creditor charges to loan money. When a business takes out a loan, they must pay interest, a cost of loaning money and the principal.

Debt Financing with Bonds

Selling bonds is considered debt financing. Bonds are a legal financial instrument sold by an entity to bring cash into an organization for expansion and growth initiatives. Let's look at an example. Jimmy Yums Donuts sells bonds for $1,000 each to the public. One of Jimmy's best customers purchases a bond and gives Jimmy Yums $1,000 in cash. The customer is considered the bondholder and Jimmy Yums is the debtor.

In return for the purchase, Jimmy Yums Donuts promises to pay the bondholder interest, which is a percentage of the $1,000 paid annually until Jimmy Yums is able to return the $1,000 to the bondholder. The $1,000 is called the principal, and the time for Jimmy Yums to return the principal is based upon the arrangement before the bond is sold.

The example above is simple compared to the very complex process of selling bonds. There are other parties involved as well as industry filings and regulations. Nevertheless, you have an idea of how the process. Now let's look at the advantages and disadvantages of financing with debt.

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