Financing plays a major role in the world of business. The reason for this important role is the fact that at some time or another any business needs financing,
most often from external sources.
Disadvantages of Debt Financing
There are a lot of advantages of obtaining capital for a business through debt financing as compared to equity financing, but there are a number of disadvantages as well. But before discussing those lets first define what debt financing actually is. It is basically obtaining a loan from some one outside the business, and then repaying the original principal borrowed along with interest at a level which has been agreed before. Following are some of the disadvantages of debt financing.
As discussed in the definition of debt financing, the first and foremost obligation of the business is to repay the money which has been borrowed from the lender. The problem lies in the fact that even though the business is not going so well and has failed, the lender still has to be repaid the money. In case the business claims bankruptcy, before repaying the equity investors the lenders will have to be paid first.
Obtaining finance from debt financing has an advantage of being tax deductible with respect to the interest payments. But even after the interest rate which has been agreed upon has been discounted from the tax deductions, the final interest rate is still most likely to be very high. These interest rates also change if there are changes in the macroeconomic conditions, the credit rating of the company, and the credit history of the business.
Another disadvantage is that whenever a loan is obtained from an outside source, in order to protect themselves from default in payments, the lender will require collateral.
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