Home / Glossary / What is debt financing?

What is debt financing?

Debt financing is a form of business finance that involves a company borrowing money from a financer, like a bank or working capital funding organization. The borrowing company is then liable to repay the money they borrowed, plus interest or a set fee, over a set period.

Debt financing is one of the most common ways for businesses to raise capital in the short term. This capital can then be used for a variety of purposes, like fueling growth, investing in inventory, or covering a cash flow shortage.

There are lots of different types of debt financing arrangements to choose from, ranging from straightforward business loans to flexible invoice financing arrangements that allow businesses to raise money against their accounts receivable.

Each one has different pros and cons, but they’re all distinguished from another popular form of business finance: equity finance.

Debt finance vs equity finance

Equity finance is the opposite of debt finance. Where debt finance involves taking out a loan that must be repaid to raise access to working capital, equity finance involves selling shares of ownership in the business to external investors to get a cash influx.

Funds raised through equity finance don’t need to be paid back, unlike those raised through debt finance. However, equity finance dilutes the ownership of existing shareholders, meaning profits have to be distributed to a larger group of owners.

The following table sums up the key differences between debt finance and equity finance:

Debt financeEquity finance
DefinitionA company borrows money from a lender and agrees to repay the loan, plus interest or a set fee, over an agreed-upon period.A company raises capital by selling shares of ownership in the business to external investors.
OwnershipThe company retains full ownership of the business.The investors own a portion of the business, in-line with the amount of capital they invest.
RepaymentThe company must repay the loan, plus interest, regardless of profitability, within a previously agreed financing term.Investors are not entitled to repayment of their investment unless the company is sold or liquidated.
RiskDebt finance is generally considered to be less risky than equity finance because the company is not giving up any ownership of the business. However, it does involve taking on temporary debt.Equity finance is generally considered to be riskier than debt finance, because investors are giving up ownership of the business in exchange for a share of its future profits and losses.

Types of debt financing

There are lots of different types of debt financing for businesses to choose from. These are three of the main options:

Business loans

Business loans, whether they come from a bank, a credit union, or an organization like the Small Business Administration, are one of the most common debt financing methods.

They give companies the chance to borrow capital, which they can use to support their operational needs or fund expansion, for example. At the point the loan is provided, repayment terms are agreed on. The borrowing company then must repay the loan amount within those terms, with the addition of interest and/or fees.

Invoice financing

Invoice financing, also known as accounts receivable financing, is a debt financing method that involves borrowing against the value of accounts receivable (or outstanding invoices).

It allows companies to get instant access to the cash they’re owed from customers, as opposed to waiting until the invoices are due. In the process, they incur a debt which is owed to the financer. When the invoices are due, the borrowing company either collects the money from their customers and repays their debt, or the financing company collects the money directly.

Invoice financing is a particularly valuable form of debt finance for funding working capital shortfalls, as it is quick, simple, and cheap. There’s generally no interest due on the debt, with a financing fee coming off the total amount instead.

Asset-based lending

Asset-based lending involves a company securing a loan using its assets, like inventory, equipment, or real estate, as collateral.

This collateralized approach means that companies can get access based on the value of their assets rather than their creditworthiness or financials. This means it’s a relatively popular form of debt financing for small or new businesses that are seeking a cash injection to grow.

Advantages of debt financing

While each specific form of debt financing has its own unique pros and cons, they all share distinct benefits compared to some other forms of business finance.

Retain business ownership

Debt financing allows businesses to gain access to capital without diluting their ownership of the company, as opposed to equity financing, which necessarily involves selling shares. This means that the company gets to keep all the rewards of its growth instead of having to share it with its financer, who becomes a shareholder.

Fuel growth with debt

Although an excess of debt can be toxic for a company, strategic debt can be instrumental in fueling growth. Businesses can use the funds they raise from debt financing to invest in research and development, make new hires, buy more inventory, or build resilience against a turbulent market.

If the revenue growth they experience because of their investment outweighs the repayment costs in the long term, the move can be considered positive.

A high degree of flexibility

Debt financing arrangements are generally highly flexible. Invoice financing agreements, for example, tend to give the borrowing company the choice of how many of their outstanding invoices to raise funds against. This is perfect for businesses that are looking for a form of financing that’s adaptable to diverse needs.

How to choose a business funding method

Choosing the right business funding method depends entirely on the circumstances your business is in and what your objectives are. Factors that will affect what the right choice for you is include:

  • Your funding requirements
  • Your business’s creditworthiness
  • The value of your accounts receivable/assets
  • Your risk tolerance

However, a method of debt financing will be a better fit for any company that doesn’t want to give up ownership for funding.

Out of the three main debt financing options – business loans, invoice financing, and asset-based lending – the choice really comes down to your specific needs.

If you’re looking for a longer-term financing solution and don’t mind paying interest, a business loan might be a good fit. Just remember, the interest payments will depend on the average interest rate at the time of your loan and your business’s credit rating.

If you want a cheap, low-risk, and flexible arrangement to boost your working capital in the short term, an accounts receivable financing solution might be the better choice.

Accounts receivable automation (or AR automation) is the practice of automating parts of the accounts receivable process in a business. Learn more here.
Flexible Funding is a feature for Taulia Payables that allows buyer organizations to use the right funding at the right time. It gives corporate treasurers options to meet their short-term cash flow needs without restricting the liquidity suppliers rely on.
A working capital funding gap is the difference between short term assets and short-term liabilities. Learn everything you need to know about funding gaps here.
The accounts receivable (AR) process is the series of actions businesses carry out to collect their accounts receivable. Learn more about it here.
The accounts receivable (AR) process is the series of actions businesses carry out to collect their accounts receivable. Learn more about it here.
Accounts receivable factoring is a way for businesses to secure financing by selling their unpaid invoices for cash. Learn more in our glossary post.
Debt financing allows businesses to borrow money to fund their short-term needs. Get a full definition and explanation in our guide to debt finance.
Working capital funding, also known as working capital financing, is a method of business financing. Learn more about the types of working capital funding here.
Integrated ERP systems refers to the combination of an ERP with integrated modules that can help you manage diverse business processes from one platform.
Lean supply chains are designed to maximize efficiency. Learn all about the principles of lean supply chain management in our glossary entry.
Learn everything you need to know about supplier segmentation, including what supplier segmentation model to use and how to tackle the process, in our guide.
What is ESG? ESG stands for environmental, social and governance. Together, these three principles form a framework that’s used to measure how sustainably, ethically, and responsibly an organization is acting. ESG is most often used to describe the efforts companies take to mitigate the potential negative outcomes of their operations. It also refers to a…
What is supply chain management? Supply chain management (SCM) describes the process businesses use to manage the flow of goods, data, and payments throughout a supply chain. Effective supply chain management is instrumental in ensuring every element of the supply chain works towards achieving broader business objectives, whether that’s cost-efficiency, resilience, quick order fulfillment, or…
What is supply chain optimization? Supply chain optimization is the process of refining the structure and operation of a supply chain. It aims to make the best use of resources and technology to extract greater efficiency and performance from the supply chain network. Well-optimized supply chains enable businesses to meet their broader objectives, whether that’s…
What is accounts receivable? Accounts receivable (AR) is the term used to describe money owed to a business by its customers for purchases made on credit. It’s listed as a current asset on the balance sheet, representing the total value of outstanding invoices for products or services sold but not yet paid for. Total accounts…
What is cash flow management? Cash flow management is the process of optimizing the flow of money in and out of a business to achieve a specific operational aim. Effective cash flow management enables businesses to use their working capital better and fuel growth or build resilience. It involves using several levers, including the approach…
What is strategic sourcing? Strategic sourcing is the term used to describe a strategic approach to the sourcing process. It involves the same fundamental steps – research, analysis, negotiation, contracting, and onboarding of new suppliers to fulfill demand for goods or services – but is oriented to contribute to broader business objectives. It also often…
What is automated spend analysis? Automated spend analysis is an automatic digital process that captures, consolidates, and interprets spend data across an organization. It’s used to provide insights into spend efficiency and effectiveness, informing sourcing and purchasing decisions. It’s typically facilitated through dedicated automated spend analysis software, usually integrated with a wider enterprise resource planning…
What is the new FASB accounting treatment for supply chain finance? In September 2022, the Financial Accounting Standards Board (FASB) — the governing body for accounting standards in the United States — updated its standards to include a requirement for SCF disclosure on company financial statements. For most organizations, disclosure of an existing SCF program…
What is spend visibility? Spend visibility refers to how well a company can understand and track how, where, and why capital is used in their business operations. Spend visibility increases when finance teams can more accurately see where company money is being spent. Low spend visibility is defined by difficulties tracking spend comprehensively or accurately….
What is 2/10 net 30? 2/10 net 30 is a trade credit often offered by suppliers to buyers. It represents an agreement that the buyer will receive a 2% discount on the net invoice amount if they pay within 10 days. Otherwise, the full invoice amount is due within 30 days. It’s one of the…
What is working capital ratio? Working capital ratio is a measurement that shows a business’s current assets as a proportion of its liabilities. It’s a metric that provides an overview of financial health and liquidity, indicating whether current liabilities can be paid by existing assets. In the case of working capital ratio, assets are typically…
What is a virtual card? A virtual card is a payment method that is virtual rather than physical. It functions similarly to a traditional credit card but takes the form of a single-use 16-digit number and three-digit CVV code generated online, instead of a plastic or metal card that is received through the post. Virtual…
What is e-procurement? E-procurement refers to the set of digital processes that dictate B2B buyer-supplier relationships in the supply chain. Utilizing technology, e-procurement aims to centralize the workflows involved in purchasing goods or services and bring about efficiency improvements. It’s essentially the digitization of the standard procurement process. E-procurement, short for electronic procurement, replaces traditional…
What is source-to-pay? Source-to-pay (or S2P) is the process that outlines how organizations fulfill their sourcing and procurement needs. It begins with the identification of demand for a product or service, encompasses steps including supplier selection, contract management, and requisition, and ends with a payment being made. It can be split into two composite sections:…
What is supplier relationship management? Supplier relationship management is the set of processes that organizations use to build, manage, and maintain relationships with their suppliers, or vendors. A supplier relationship management strategy is essential to ensure that relationships are built productively, with a view to increasing the overall effectiveness and resilience of the supply chain….
What is supplier information management? Supplier information management (SIM) refers to the set of processes or the system that organizations use to collect, store, access, and update important data about their suppliers. From contact details to contractual documentation, the data involved in supplier information management is essential in the broader process of vendor management. A…
What is AP automation? AP automation, short for accounts payable automation, is the use of software to automate part or all of the accounts payable process. It aims to create efficiency in the accounts payable workflow by digitizing how vendor invoices are received, processed, and stored. In removing manual processes and the need for paper-based…
What is accounts payable? Accounts payable (AP) represents the amount that a company owes to its creditors and suppliers (also referred to as a current liability account). Accounts payable is recorded on the balance sheet under current liabilities. When a business purchases goods or services from a supplier on credit, payment isn’t made straight away,…
What is accounts receivable (AR) financing? Accounts receivable or AR financing is a type of financing arrangement which is based on a company receiving financing capital in return for a chosen portion of its accounts receivable. An AR financing arrangement can be structured in several ways, including as an asset sale or a loan. Essentially,…
What is the cash conversion cycle (CCC)? The cash conversion cycle (CCC) – also known as the cash cycle – is a metric expressing how many days it takes a company to convert the cash it spends on inventory back into cash by selling its product. The shorter a company’s CCC, the less time it…
What is cash flow forecasting? Cash flow forecasting, also known as cash forecasting, estimates the expected flow of cash coming in and out of your business, across all areas, over a given period of time. A short-term cash forecast may cover the next 30 days and can be used to identify any funding needs or…
What is Days Inventory Outstanding? (DIO) Days inventory outstanding (DIO) is a working capital management ratio that measures the average number of days that a company holds inventory for before turning it into sales. The lower the figure, the shorter the period that cash is tied up in inventory and the lower the risk that…
What is Days Payable Outstanding? (DPO) Days payable outstanding (DPO) is a useful working capital ratio used in finance departments that measures how many days, on average, it takes a company to pay its suppliers. As such, DPO is an important consideration when it comes to managing a company’s accounts payable – in other words,…
What is Days Sales Outstanding? (DSO) Days sales outstanding (DSO) is a working capital ratio which measures the number of days that a company takes, on average, to collect its accounts receivable. The shorter the DSO, the faster the company collects payment from its customers – and the sooner it is able to make use…
What is dynamic discounting? Dynamic discounting is a solution that provides suppliers with the option of receiving early payment in exchange for a discount on their invoice. As a result, suppliers can typically access lower cost funding than they might otherwise receive, while harnessing working capital in order to invest in growth and innovation. Buyers, meanwhile,…
What is an early payment discount? An early payment discount is a form of trade finance, allowing buyers to pay a discounted amount to suppliers in exchange for settling invoices before their maturity date. Also known as a prompt payment discount or early settlement discount, it’s typically calculated as a percentage of the goods and…
What is inventory management? Inventory management is a systematic approach to sourcing, storing, and selling inventory. Effective inventory management involves optimizing the flow of goods within an organization, from purchase right through to sale, always ensuring that an appropriate quantity is available in the right place and at the right time to meet customer demand. Inventory in…
What is invoice processing? Invoice processing is a business function that involves managing incoming invoices from initial receipt through to payment. It’s carried out by the accounts payable department and is a critical component of the procure-to-pay process as the final step of any procurement activity. The invoice processing cycle is made up of several composite…
What is inventory cycle time? Inventory cycle time is the amount of time it takes to produce and deliver an order from a customer, usually measured in days. It essentially measures the speed at which a company can complete the manufacturing or assembly process from start to end, turning raw materials or components into a…
What is procure-to-pay? (P2P) Procure-to-pay is a term that encompasses the processes which take place when a company purchases, receives and pays for goods and services. The activities that make up the procure-to-pay process range from identifying the initial need for procurement of goods or services to the final steps of approving invoices and paying…
What is the procurement life cycle? The procurement cycle is the process businesses use to find and obtain goods. It involves multiple steps, including identifying the need for a good or service, finding the right supplier, negotiating terms, creating a purchase order, and receiving the delivery. It’s also known as the procurement life cycle or,…
What is receivables finance? Receivables finance, or receivables financing, is a trade finance method businesses can use to receive funding matching the amounts owed to it by its customers in outstanding invoices. These amounts are known as trade receivables or accounts receivable. By financing its receivables, a business can receive payments earlier, meaning it can…
What is reverse factoring? Reverse factoring is a type of supplier finance solution that companies can use to offer early payments to their suppliers based on approved invoices. Suppliers participating in a reverse factoring program can request early payment on invoices from the bank or other finance provider, with the buyer sending payment to the…
What is trade finance? Trade finance is the term used to describe the tools, techniques, and instruments that facilitate trade and protect both buyers and sellers from trade-related risks. The purpose of trade finance is to make it easier for businesses to transact with each other. It also helps to reduce the risks involved in…
What are trade receivables? Trade receivables are defined as the amount owed to a business by its customers following the sale of products or services on credit. Also known as accounts receivable, trade receivables are classified as current assets on the balance sheet. Most companies allow their customers to use credit on purchases of goods…
What is strategic procurement? Strategic procurement, or procurement strategy, is the process businesses use to acquire goods or services of the right quality, at the right price, and in time to meet customer demand. It brings procurement activities in-line with a company’s broader objectives, while also reducing supply chain risk. Strategic procurement is a long-term, organization-wide…
What is supply chain finance? Supply chain finance, also known as supplier finance or reverse factoring, is a financing solution in which suppliers can receive early payment on their invoices. Supply chain finance reduces the risk of supply chain disruption and enables both buyers and suppliers to optimize their working capital. Unlike other receivables finance…
What is vendor management? Vendor management is a term that describes the processes organizations use to manage their suppliers, who are also known as vendors. Vendor management includes activities such as selecting vendors, negotiating contracts, controlling costs, reducing vendor-related risks and ensuring service delivery. The vendors used by a company will vary considerably depending on…
What is working capital management? Working capital management is a business process that helps companies make effective use of their current assets and optimize cash flow. It’s oriented around ensuring short-term financial obligations and expenses can be met, while also contributing towards longer-term business objectives. The goal of working capital management is to maximize operational…