What is Debt Financing?
Debt financing is the use of borrowing to pay for things.
How Does Debt Financing Work?
For example, the basic idea behind acquisition debt financing is that the 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 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 in the open . Because the combined entity often has a high debt/equity ratio (near 90% debt, 10% ), 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 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 Does Debt Financing Matter?
Debt financing allows companies to make Warren Buffett, looks very carefully at a company's burden before , and many of his holdings had relatively low when he invested. He prefers companies that fuel future growth through shareholder equity. Buffett hasn't wavered in his focus on . As he said in his 1987 letter to shareholders, "Good business or decisions 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 or other deal involving a of . This, however, can be a buying opportunity if investors think the company be able to pay down the , which increases the value of the . 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 .