Debt financing means borrowing funds or arranging for investments from outside sources. Large-scale companies and organizations cannot manage all their affairs with their own capital, so it is common for them to apply for loans. The most frequent example of this type of financing are loans taken from banks. The loan amount must be repaid in agreed installments along with interest at a specified rate.
Debt Financing Merits:
The following are the merits of debt financing:
(i) Scope of expansion: Debt financing allows companies to expand their operations. New branches can be opened in other cities and countries. New lines of business can be adopted to increase revenue. The easy availability of credit encourages the entrepreneur to take new risks and launch new products. It also enables entrepreneurs to scale up their operations and update their products on time.
(ii) Research and Development: Debt financing enables the research and development process. Loans taken from banks can be used to speed up R&D activities. The company’s revenue potential increases when hard research products float on the market. The new innovation, in addition to increasing the reputation of companies, also reduces their cost of production.
(iii) High profit: Due to the expansion of the business and the use of new techniques, the income and profit of the business also grows. The huge revenue means there will be room for further expansion of the business. The higher profits can also be used to pay off bank loans. Thus increasing the solvency of businesses.
(iv) Working Capital Facility: Debt financing helps maintain adequate working capital for the business. It also provides a space to make regular payments with ease.
(v) Reactivation of Sick Units: Debt financing can be used to give ailing industrial units a breather. The organization’s loans can be rescheduled and new credits can be taken for such units so that they can start their production. In addition to providing funding, proper supervision and guidance must also be provided. All of this will rehabilitate ailing units and can help them become successful and profitable units.
(v) Insolvency Savings: Debt financing can be used to save the company from insolvency. In case of any essential payment is to be done and there are not enough capital funds, then a loan can be taken out to make the payments and save the business from insolvency.
(vi) Tax advantage: Since the interest charge is subtracted from net income before the tax rate is applied, this leads to less tax liability.
Demerits of debt financing:
The following are the demerits of debt financing:
(i) Interest payments: A very large amount of the net profit of the business must be paid on account of the interest on the principal borrowed.
(ii) Depression: If a company goes into a slump and losses occur, then interest payments could become a big problem due to insufficient funds.
(iii) Lawsuit against companies: The creditor can file lawsuits against the business if the business fails to make payments as agreed.
(iv) Seizure of Guarantees: If the business does not pay interest on the principal amount of the loan, the bank may repossess the collateral or mortgaged property.
(v) Risky Investments: If a company is already running on the huge borrowed capital, further investment in a company becomes risky. This risk discourages investors. Banks are also hesitant to lend to these types of companies that are already under the burden of debt.
