A borrowed funds or debt financing is the combination of the funds raised by the way of credit or loans. It is the proceeds of an organization to raise the operating or other capital by borrowing. Most frequently, this may be achieved through issuance of a debenture, bond or many other kind of debt security. In substitute for providing the money, bond or debenture, owners become creditors of the organization. They are permitted to the amount of interest and are required to transfer their loan at the end of a given time period.
Debt financing can be short-term or long-term. Short-term debt financing consists of debt securities with shorter deliverance time periods and it is used to offer day-to-day provisions; for example payroll and inventory etc. On the other hand, Long-term debt financing generally engages a firm to acquire or buy the fundamental necessities for its business, for instance major assets and facilities. Debt financing is generally known as borrowed capital. The collection of borrowed funds depends upon different types of business organizations which are given as:
|Sole Proprietorship||Funds are raised by the owners by giving the personal security or giving the security of their existing assets.|
|Partnership Firm||Here funds are raised by partner by giving the personal security or the security of existing assets.|
|Company||Loans are raised by issuing debentures through credit or loans.|
Characteristics of Debt Financing or Borrowed Capital
1. Fixed obligations: Debt financing has the following two fixed obligations which are given as:
- Interests amount is payable at yearly are half yearly interval. It is payable as a charge against the earnings irrespective of the fact whether there are losses or profit.
- The principle capital is payable as termed.
2. No right of control over management
Creditors and lenders usually do not have any right of control over the borrowed organization’s management.
3. Not Permanent Capital
A debt financing or borrowed fund is not a permanent capital to the organizations because it is given for particular period. It cannot be used permanently by organizations but they have to repay at the specified terms and conditions.
Advantages of Debt Financing or Borrowed Capital
- Advantage of trading on equity
- Tax advantage to the firm: Debt financing can be used to lower the rate of tax payment by showing higher debts in the financial statements.
- Appropriate time horizon: Debt is always paid for certain period of time; therefore, organizations can utilize the fund accordingly and prepare themselves for the repayment.
- No interference in management: Management is free from any interference from creditors.
- Flexibility in the capital structure: Debt financing makes the capital structure flexible by having both debt and equity.
Disadvantages of Debt Financing or Borrowed Capital
- Payment of credit: The principal capital is paid at the every due date without any apprehension to the financial creditors of a firm.
- Interest payment: Interest amount is regularly paid by a firm whether it is earning profits or losses.
- Interest rate in crisis: During the worst economic conditions, interest rate remains same but the rate of return (ROR) falls due to which firms suffer losses.
- Maturity of loans: If the sufficient amount is not available to pay the loans at the period of loan maturity, a firm could be declared insolvent.
Limitations of Debt Financing or Borrowed Capital
- Need for security
- Risk for efficient functioning
- Fixed financial burden on company
- Reduced credit worthiness