Debt financing means to borrow funds or to arrange for investments from external sources. Large-scale businesses and organizations are not able to run all their affairs from their own capital so it is usual for them to take loans. The most prevalent example of this type of finance is the loans taken from banks. The amount of the loan is to be repaid in agreed installments along with interest at a specified rate.
Merits of Debt Finance:
Following are the merits of debt finance:
(i) Scope for Expansion: Debt financing allows business to expand its operations. New branches can be opened in other cities and countries. New lines of business can be adapted to increase revenues. The easy availability of credit encourages entrepreneur to take new risks and float new products. It also enables businessmen to increase the scale of their operations and to upgrade their products in time.
(ii) Research and Development: Debt financing allows the process of research and development. Loans taken from banks can be used to accelerate R & D activities. Earning potential of the company increases when the research hard products are floated in the market. The new innovation, besides increasing companies reputation, also reduces its cost of production.
(iii) High Profit: Due to expansion of business and use of new techniques the revenues and profits of the business also grow. Huge revenues means that there will be a room for further expansion of the business. Higher profit can also be used to repay the bank loans. Thus increasing the solvency of business.
(iv) Ease of Working Capital: Debt financing helps in maintaining adequate working capital of the business. It also provides a room for making regular payments easily.
(v) Revival of Sick Units: Debt financing may be used to give a breathe to the sick industrial units. The organization’s loans can be rescheduled and new credit can be taken for such units so that they can start their production. Besides providing finance, proper supervision and guidance should also be given. All this will rehabilitate the sick units and can help them to be successful and profitable units.
(v) Saving from Insolvency: Debt financing may be used to save the business from insolvency. In case any essential payment is to be made and there are not enough equity funds then a loan can be taken to make payments and to save the business from insolvency.
(vi) Tax Advantage: As the interest charge is subtracted from net income before applying tax rate, so this leads to lower tax liability.
Demerits of Debt Finance:
Following are the demerits of debt financing:
(i) Interest Payments: Very huge amount out of the net profit of the business have to be paid on account of interest on borrowed capital.
(ii) Depression: If a business comes under depression and losses occur, then the payments of interest could become a great problem due to an inadequacy of funds.
(iii) Suit Against Business: Creditor can file suits against a business if the business fails to make payments as agreed.
(iv) Seizing of Collateral: If the business fails to pay interest on the capital amount of loan the bank could seize the collateral or mortgaged property.
(v) Risky Investment: If a business is already running on the huge borrowed capital, further investment in a business becomes risky. This risk discourages investors. Banks also hesitate to grant loans to such business which are already under debt burden.