21 May 2022
Debt Financing
When a company needs money, there are three ways to obtain financing: sell equity, take on debt, or use some hybrid of the two. Debt financing involves the borrowing of money and paying it back with interest and the most common form of debt financing is a loan. Debt means the amount of money that needs to be repaid and financing means providing funds to be used in business activities. Debt Financing is when a company borrows money to be paid back at a future date with interest. An important feature in debt financing is the fact that you are not losing ownership in the company which means that the lender does not take an equity position in your business. The most common forms of debt finance include Traditional bank loans, Personal loans, Loans from family or friends, Government loans, including Small Business Administration (SBA) loans, peer-to-peer loans, home equity loans, lines of credit, credit cards, real estate loans, overdrafts, mortgages, credit cards, and equipment leasing/hire purchase. It could be in the form of a secured as well as an unsecured loan. The loan is secured or collateralized with the assets of the company taking the loan which is usually part of the secured loan. If the loan is unsecured, the line of credit is usually less.
A firm takes up a loan to either finance working capital or an acquisition. If a company needs a big loan then debt financing is used, where the owner of the company attaches some of the firm’s assets and based on the valuation of those assets, the loan is given. It is also an expensive way of raising funds because the company has to involve an investment banker who will systematically structure big loans. It is a viable option as interest costs are low and the returns are better. Small and especially new companies rely on debt financing to buy resources that will facilitate the growth of the company. For example, If a company requires a loan of Rs 10 crore, it can raise the capital by selling bonds or notes to institutional investors.
Why choose Debt Financing and How does it work?
A company can choose debt financing, which entails selling Fixed Income products, such as bonds, bills, or notes, to investors to obtain the capital needed to grow and expand its operations. It occurs when a firm raises money for working capital or capital expenditures by selling debt instruments to individuals and/or institutional investors. When a company issues a bond, the investors that purchase the bond are lenders (creditors) who are either retail or institutional investors that provide the company with debt financing. The amount of the investment loan—also known as the principal along with the interest on the debt must be paid back at some agreed date in the future. The payments could be made monthly, half-yearly, or towards the end of the loan tenure. If the company goes bankrupt, lenders have a higher claim on any liquidated assets than shareholders. One advantage of debt financing is that it allows a business to leverage a small amount of money into a much larger sum, enabling more rapid growth than might otherwise be possible. Another advantage is that the payments on the debt are generally tax-deductible. There can be two types of Debt Financing Short-term and Long-term. Short-term financing is commonly used by businesses that tend to have temporary cash flow issues when sales revenues are insufficient to cover current expenses. Startup businesses are particularly prone to cash flow management problems. Credit cards are a popular source of short-term financing for small businesses. In fact, according to a U.S. National Small Business Association study, 59% of small business owners used credit cards for financing in 2017. With long-term debt financing, the scheduled repayment of the loan and the estimated useful life of the assets often extends for three- to seven-year terms. Loans guaranteed by the SBA can provide terms up to 10 years. So a company can choose whether short-term or long-term financing will be
A company undertakes debt financing because they don’t have to put its capital. The main disadvantage of debt financing is that interest must be paid to lenders, which means that the amount paid will exceed the amount borrowed. Debt payments must be made regardless of business revenue, and this can be particularly risky for smaller or newer businesses that have yet to establish a secure cash flow. But too much debt is also risky and thus, companies have to decide on a level (debt to equity ratio) that they are comfortable with.
Most companies will need some form of debt financing. Additional funds allow companies to invest in the resources they need to grow. Small and new businesses, especially, need access to capital to buy equipment, machinery, supplies, inventory, and real estate. The main concern with debt financing is that the borrower must be sure that they have sufficient cash flow to pay the principal and interest obligations tied to the loan.
Debt Consolidation
When you consolidate your credit card debt, you are taking out a new loan. Consolidation means that your various debts, whether they are credit card bills or loan payments, are rolled into one monthly payment with reduced interest rates. Debt consolidation is a strategy that allows debtors to escape the debt trap by merging multiple debts into one so that they can be repaid easily via a management program or loan. Debt consolidation programs are highly effective in dealing with high-interest debts like credit cards and work by lowering the applicable interest making it convenient for the debtor to repay the debt. It reduces the financial burden on the debtor making it easier for them to make ends meet during such phases of financial instability. The relaxation obtained by the debtor is mainly due to the fact the debt-relief strategies compile the debts into a single source leading to one payment once a month which saves money and offers peace of mind. It refers to the act of taking out a new loan to pay off other liabilities and consumer debts, generally unsecured ones. Multiple debts are combined into a single, larger piece of debt, usually with more favourable payoff terms. By doing this they save on interest as well as the finance cost of the small loan owed by them.
Debt consolidation is a form of debt refinancing those entails taking out one loan to pay off many others. This commonly refers to a personal finance process of individuals addressing high consumer debt, but occasionally it can also refer to a country's fiscal approach to consolidate corporate debt or Government debt.
Debt consolidation can be classified mainly into two categories based on the framework they follow to settle the debt, here’s a rundown-
- Opting for a loan to settle the debt
- Opting for a management program to settle the debt.
The borrower would now have to make one payment instead of making multiple payments to other creditors. Favourable payoff terms include a lower interest rate, lower monthly payment, or both. Hence, instead of paying to multiple creditors, they will pay to only one, thereby saving money and eventually becoming debt-free. The debts that can be consolidated are Credit Card Debt, Personal Loans, and Credit Lines. Consolidation can be termed as one of the most powerful tools for debt elimination. Financial liability in terms of multiple loans or credit cards is to be best handled by availing the option of a ‘Debt consolidation. Debt consolidation can happen on debts that are not tied up to an asset. Education loans, the amount owed on a credit card, and personal loans are some examples of unsecured loans which can come under debt consolidation.
Debt Consolidation also allows you better control of your finances by consolidating all your outstanding liabilities into one loan. It allows you to waive off paying high-interest rates on all your liabilities by providing you with a lower consolidated interest rate, a Flexible repayment plan, better financial control, Allows you to create savings on the interest payments that would have been otherwise applicable, Allows you more disposable income and helps in better finances.
There are several ways you can lump your debts together by consolidating them into a single payment like Personal loans which are used to consolidate credit card debt are a way of turning multiple balances into a single monthly payment, Credit cards are another method to consolidate all your credit card payments into a new credit card. Home equity loans (HELOCs) are another form of consolidation. Where usually the interest for this type of loan is deductible for taxpayers who itemize their deductions. Let’s say that you have outstanding dues on multiple credit cards that are attracting a very high rate of interest, plus an existing high-interest personal loan. In such a case, it would prove meaningful to consolidate all the debt into one personal loan. To do so, avail of a fresh personal loan from a bank that offers a lower interest rate.
Debt consolidation is an effective process that helps people to combat their outstanding financial obligations without struggling. Here are some of the major benefits of debt consolidation-
- Easy to look after deadlines of payments
- The rate of interest is comparatively lower
- Helps to maintain a credit score
- Provides peace of mind and reduces stress
- The lesser amount of capital spent monthly to consolidate debt
Banks offering Debt Consolidation loans in the UAE are Abu Dhabi Islamic Bank Debt Consolidation Loan, Mashreq Bank Debt Consolidation Loan, and FAB Debt Consolidation Loan. Let’s take the example of a person who has outstanding liabilities as follows: based on two credit cards AED 25,000/- and AED 20,000/- respectively and a separate personal loan for AED 150,000/-. In normal instances, a separate interest percentage will apply to each outstanding liability, and a fixed instalment payment will apply accordingly for each. When you proceed to consolidate the loan, the bank treats this as one outstanding liability and provides you with revised lower interest and instalment figures at competitive rates, which provide considerable savings.
When you can avoid finance from a formal source, it will usually be more advantageous for your business. If you do not have family or friends with the means to help, debt financing is likely the easiest source of funds for small businesses. As your business grows or reaches later stages of product development, equity financing or mezzanine capital may become options. When it comes to financing and how it will affect your business, less is more.
Debt Consolidation and Debt Financing are both financial strategies for improving personal debt load, but they function quite differently and are used to resolve different issues. At a very basic level, debt settlement is useful for reducing the total amount of debt owed, while debt consolidation is useful for reducing the total number of creditors you owe. It is possible to receive secondary benefits through either strategy, particularly debt consolidation. It helps you reduce your debt load, but they do so in different ways and by using different strategies. Debt Financing helps cut your total debt owed, while debt consolidation is useful for cutting the total number of creditors that you owe.
Therefore, with Debt Consolidation, multiple loans are all rolled into a new consolidation loan that has one monthly interest rate. With Debt Financing, either you or a credit counsellor negotiates with your creditors so that you can pay a lower amount than what you owe, often in a lump-sum settlement. Both are beneficial to the business industry, the banking sector as well as individuals in the UAE. The UAE, therefore, has introduced a new insolvency law to support financially insolvent individuals in the country. Also, it aims to enhance the UAE’s competitiveness in the ease of doing business. The UAE Cabinet approved the new insolvency law which is expected to benefit the economy and the banking sector. It is introduced three years after the UAE government passed a similar insolvency law for organizations in 2016.
Individuals will have an opportunity to restructure their debts in a favourable environment and protect those who are unable to pay the debt from going bankrupt through Debt Financing and Debt Consolidation. It takes a soft approach toward debt settlement—and provisions of the new law will allow insolvent individuals to acquire new concessional loans by approaching these means. Therefore, the law is a well-defined legal and regulatory framework for both companies and individuals.
As the UAE advances its positioning as a regional economic hub and financial haven, regulations too will evolve to support the financial well-being and stability of local entrepreneurs and business owners. Analysts and entrepreneurs believe that the new law will have a positive effect on the economy in the long run.