Debt financing means borrowing funds or organizing 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 common example of this type of financing is loans from banks. The loan amount will be repaid in agreed installments along with interest at a specified rate.
Merits of debt financing:
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 accelerate R&D activities. The profit potential of the company increases when hard research products are launched 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 profits of the business also grow. The huge revenues mean there will be room for further business expansion. Higher profits can also be used to repay bank loans. Thus increasing the solvency of the business.
(iv) Ease of working capital: Debt financing helps maintain adequate working capital for the business. It also provides a space to make regular payments easily.
(v) Reactivation of sick units: Debt financing can be used to give ailing industrial units a break. The organization’s loans can be rescheduled and new credits can be taken for these units so that they can start production. In addition to providing financing, 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) Savings in case of insolvency: Debt financing can be used to save the business from insolvency. In case of an essential payment it is and there are not enough capital funds, then a loan can be taken to make the payments and save the company from insolvency.
(vi) Tax advantage: Since the interest charge is subtracted from net income before the tax rate is applied, this leads to a lower 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 company must be paid on account of the interest on the capital borrowed.
(ii) Depression: If a business falls into a depression and losses occur, then interest payments could become a big problem due to insufficient funds.
(iii) Lawsuit against businesses: 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 could convert the property as collateral or mortgaged.
(v) Risky investment: If a business is already running on huge borrowed capital, further investment in a business becomes risky. This risk discourages investors. Banks are also hesitant to grant loans to these types of companies that are already burdened with debt.
