Advantages and Disadvantages of Debt Financing

By Welch Capital Partners on
June 12, 2023

What are the advantages and disadvantages of debt financing?

The most common type of debt financing that many of us live with is a mortgage on our house. This provides a good example of the biggest advantage of debt financing. It allows us to make a large purchase that we would otherwise have to wait years to make by saving up. It is an investment that provides us the opportunity to enjoy living in our home without having to pay for it all upfront.

This is similar to businesses. Taking on debt allows businesses to make purchases that they might otherwise not be able to make. Certain obligations (covenants) do come with debt. The types of obligations will differ depending on the type of debt and the debt provider. A couple of examples are the debt-to-equity ratio (which shows how much debt a company has compared to its equity, which is used to demonstrate a company's ability to meet its obligations) and the current ratio (current assets over current liabilities). It is used to show a company’s ability to meet its short-term obligations). No matter who the debt provider is, they will need to get paid back. This means the company will need to generate sufficient cash flow to pay back the lender. If used properly, though, debt allows a business to grow (and its shareholders to build value) by using a third party's capital.

If a company cannot obtain debt or does not want to put the strain of having to repay a loan on its cash flow, it can look at taking on equity. This means that existing shareholders will give up a percentage of ownership in the company in exchange for the capital. In theory, this capital should allow the company to grow such that the shareholders now own a smaller piece of a larger pie. They will have the cash to grow their business without the obligations of having to repay a loan or meet other covenants.

Between traditional bank debt and equity, there are funding mechanisms that provide aspects of both. This includes mezzanine financing, which has flexible payment terms (interest only, accrued interest royalty) but carries a higher interest rate, and quasi-equity (e.g., convertible notes, which are loans that, if not repaid in a defined period, convert to equity at a discount).

The right capital structure for each business is unique. Please reach out to Connor McGarry at cmcgarry@welchcapitalpartners.com to determine what that structure should be and to source the capital providers to fulfill the structure.

What are the advantages and disadvantages of debt financing?

The most common type of debt financing that many of us live with is a mortgage on our house. This provides a good example of the biggest advantage of debt financing. It allows us to make a large purchase that we would otherwise have to wait years to make by saving up. It is an investment that provides us the opportunity to enjoy living in our home without having to pay for it all upfront.

This is similar to businesses. Taking on debt allows businesses to make purchases that they might otherwise not be able to make. Certain obligations (covenants) do come with debt. The types of obligations will differ depending on the type of debt and the debt provider. A couple of examples are the debt-to-equity ratio (which shows how much debt a company has compared to its equity, which is used to demonstrate a company's ability to meet its obligations) and the current ratio (current assets over current liabilities). It is used to show a company’s ability to meet its short-term obligations). No matter who the debt provider is, they will need to get paid back. This means the company will need to generate sufficient cash flow to pay back the lender. If used properly, though, debt allows a business to grow (and its shareholders to build value) by using a third party's capital.

If a company cannot obtain debt or does not want to put the strain of having to repay a loan on its cash flow, it can look at taking on equity. This means that existing shareholders will give up a percentage of ownership in the company in exchange for the capital. In theory, this capital should allow the company to grow such that the shareholders now own a smaller piece of a larger pie. They will have the cash to grow their business without the obligations of having to repay a loan or meet other covenants.

Between traditional bank debt and equity, there are funding mechanisms that provide aspects of both. This includes mezzanine financing, which has flexible payment terms (interest only, accrued interest royalty) but carries a higher interest rate, and quasi-equity (e.g., convertible notes, which are loans that, if not repaid in a defined period, convert to equity at a discount).

The right capital structure for each business is unique. Please reach out to Connor McGarry at cmcgarry@welchcapitalpartners.com to determine what that structure should be and to source the capital providers to fulfill the structure.

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