It's a misconception that Debts Fund have no risk just because they don't invest in equities. It's true that Debt Funds are less risky compared to Equity Funds but that doesn't mean Debt Funds guarantee that your money will never face any loss.
Drawbacks of debt financing
Having high interest rates – Interest rates vary based on various factors including your credit history and the type of loan you're trying to obtain.
This is because debt finance is safer from a lender's point of view. Interest has to be paid before dividend. In the event of liquidation, debt finance is paid off before equity. This makes debt a safer investment than equity and hence debt investors demand a lower rate of return than equity investors.
Debt financing can be limited by credit score requirements, as well as borrowing limits, rates, and the associated fees. Regardless of whether a business succeeds, repayment, including the principal loan and interest, is required.
Cons of debt finance
The most obvious drawback is that capital raised via debt must be repaid. This means the business must be confident in its growth assumptions and have a clear plan for how it will use debt finance, so that the loan is serviceable and the business does not struggle to meet the repayment schedule.
Is Debt Financing or Equity Financing Riskier? It depends. Debt financing can be riskier if you are not profitable, as there will be loan pressure from your lenders. However, equity financing can be risky if your investors expect you to turn a healthy profit, which they often do.
Debt Financing Over the Short-Term
A common type of short-term financing is a line of credit, which is secured with collateral. It is typically used with businesses struggling to keep a positive cash flow (expenses are higher than current revenues), such as start-ups.
Wealthy family borrows against its assets' growing value and uses the newly available cash to live off or invest in other assets, like rental properties. The family does NOT owe taxes on its asset-leveraged loans because the government doesn't tax borrowed money.
Debt financing includes bank loans, loans from family and friends, government-backed loans such as SBA loans, lines of credit, credit cards, mortgages, and equipment loans.
See an expert-written answer! The major disadvantage of debt financing is the inability to deduct interest expenses for income tax purposes. Equity is the owner's investment in the business. Financial management is the art and science of managing a firm's money so the firm can meet its goals.
Overnight Funds
These overnight instruments are backed by collateral which comprises of Government Securities, and so these funds also have no credit risk. These are the safest debt funds but their yield is usually also the lowest. Overnight funds are suitable for parking your funds for a few days.
A risk-free asset is one that has a certain future return—and virtually no possibility of loss. Debt obligations issued by the U.S. Department of the Treasury (bonds, notes, and especially Treasury bills) are considered to be risk-free because the "full faith and credit" of the U.S. government backs them.
Some of the major risks in these instruments/funds are: 1) Interest risk- This is also known as price risk. Whenever there is a change is the interest rates the price of a debt instrument also changes.
Tax Consequences. Debt financing is treated favorably under U.S. tax law. Businesses can deduct the interest payments they make on their loans or bonds, which lowers the overall cost of financing. Businesses can sometimes even take interest deductions when they haven't made any interest payments.
The main difference between debt fund and equity fund is that debt funds have considerably lesser risks compared to equity funds. The other major difference between debt mutual fund and equity mutual fund is that there are many types of debt funds which help you invest even for one day to many years.
What are the pros and cons of debt financing? Pros of debt financing include immediate access to capital, interest payments may be tax-deductible, no dilution of ownership. Cons of debt financing include the obligation to repay with interest, potential for financial strain, risk of default.
Debt financing may have more long-term financial benefits than equity financing. With equity financing, investors will be entitled to profits, and if you sell the company, they'll get some of the proceeds too. This reduces the amount of money you could earn by owning the company outright.
The advantages of borrowing money is that it can facilitate more operational opportunities than funds provided solely through equity or operations and preserves ownership.
During periods of financial instability, banks may increase their interest rates on loans, potentially impacting your ability to make regular payments. Some loans may also use your credit score to determine the interest rate.
Since lenders are not entitled to a share of your business, so they have no say in how it is run. Debt financing can also be cost-effective. The interest rates on borrowed money are often lower than the cost of equity, and the interest paid is tax-deductible.
Generally, a good debt ratio for a business is around 1 to 1.5. However, the debt-to-equity ratio can vary significantly based on the business's growth stage and industry sector. For example, newer and expanding companies often utilise debt to drive growth.
Types of Debt Financing
The most common forms are: Bonds: sometimes referred to as 'fixed income' debt securities, bonds are more typically associated with publicly listed firms, but can also be issued by private companies through certain intermediaries.