Business is in continuous need of funds for working capital needs or for incurring capital expenditures. A business can finance its operations either through equity or debt. Debt financing occurs when a firm raises money for working capital or capital expenditures by selling debt instruments to individuals or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid. Debt may take the form of a loan or the sale of bonds; the form itself does not change the principle of the transaction: the lender retains a right to the money lent and may demand it back under conditions specified in the borrowing arrangement. The other way to raise capital in the debt markets is to issue shares of stock in a public offering; this is called equity financing.
SOURCES OF DEBT FINANCING
Small businesses can get debt financing from a number of different sources. Private sources of debt financing comprise friends and relatives, banks, credit unions, consumer finance companies, commercial finance companies, trade credit, insurance companies, factor companies, and leasing companies. Public sources of debt financing comprise a number of loan programs provided by the state and federal governments to support small businesses.
- Loans: Loans are the most common and popular mode of debt finance for a company. Businesses borrow money from commercial lenders like banks by keeping some collateral security against the loan.
- Trade Credit: Trade creditis an agreement in which the business can buy the goods at present and pay for them later. This way the business can avail debt financing for the short term. Trade credit is a good mode of finance for beginners.
- Installment Purchase: Purchasing the capital goods on installment is another type of debt financing.
- Asset-Based Lenders: Asset-based lenders are those finance companies that lend money to the business for purchasing the assets.
- Bonds: Bondare a source of debt capital for businesses that are well recognized and require funds for the long-term growth of the business.
- Insurance Companies: Insurance companies perform as a main source of finance for small companies. They provide two types of loans to the businesses namely; mortgage loan and policy loan.
Debt financing is the second most popular source of financing for businesses, the first one is equity financing. Debt financing allows the business to not only congregate its working capital requirements but also enlarge its business. The business requires funds at regular period and the entire financial conditions cannot be handling with equity financing after a certain point of time. In such scenarios, debt financing acts as a helping hand to fulfill the financial needs of the business. So it considers as the best source of financing which increases the efficiency of business.
Sidra Ghafor, Pakistan