Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Debt Financing

What it is:

Debt financing is the use of borrowing to pay for things.

How it works (Example):

For example, the basic idea behind acquisition debt financing is that the acquirer purchases the target with a loan collateralized by the target’s own assets. To obtain debt financing, the acquirer must therefore first make sure the target’s assets are adequate collateral for the loan needed to purchase the target. The acquirer must also create and study financial forecasts of the combined entities to make sure they generate enough cash to make the principal and interest payments. In some cases, maintaining optimal cash flow could be a real challenge if the target’s management team leaves after the acquisition.

Once the acquirer has determined that the debt is financially feasible, it works on raising the debt. In some cases, the debt comes directly from one or more banks. In other cases, the acquirer issues bonds in the open market. Because the combined entity often has a high debt/equity ratio (near 90% debt, 10% equity), the bonds are usually not investment grade (that is, they are junk bonds).

Obtaining debt financing is often expensive and complicated. An investment bank, a law firm and third-party accountants are often necessary to structure big transactions correctly.

The pursuit of debt financing usually increases when interest rates are low -- which reduces the cost of borrowing and encourages investors to seek high-return opportunities -- and/or when the economy or a particular industry is underperforming (which pushes company values down). However, an increase could also signal more demand for goods or a positive economic outlook.

Why it Matters:

Debt financing allows companies to make investments without having to commit a lot of their own capital, but the even greater purpose is to maximize shareholder value. As in personal finance, too much debt can be a very, very bad thing, but a little can go a long way. For most investors, it is thus usually unwise to avoid investing in companies with debt; the trick is to find companies that manage their debt well. The world's most popular investor, Warren Buffett, looks very carefully at a company's debt burden before investing, and many of his equity holdings had relatively low debts when he invested. He prefers companies that fuel future growth through shareholder equity. Buffett hasn't wavered in his focus on leverage. As he said in his 1987 letter to shareholders, "Good business or investment decisions will eventually produce quite satisfactory economic results, with no aid from leverage."

This high level of risk associated with debt financing is why share prices usually fall when a company announces news of an acquisition or other deal involving a lot of debt. This, however, can be a buying opportunity if investors think the company will be able to pay down the debt, which increases the value of the shares. Note that off-balance-sheet financing is an accounting method whereby companies record certain assets or liabilities in a manner that prevents those items from appearing on the balance sheet.