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Definition of Debt Financing

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Definition:

Debt financing is a method of obtaining capital to operate by a business through borrowing money. Businesses borrow money from a variety of commercial sources and then have to pay it back under the terms they negotiate with their source. They pay back the principal that they borrow plus whatever rate of interest they are charged. The interest rate is the rent for the use of the money that is borrowed.

The most often used source of debt financing by small businesses is commercial banks. Commercial banks exist to make loans to businesses and individuals and accept deposits. There are also alternative sources of debt financing for small businesses.

There are advantages and disadvantages of debt financing. There are two financial ratios that can help a business owner determine the debt position of the company. The first is the debt to equity ratio which will show the business owner how much debt financing is being used. The second ratio is the debt to assets ratio which tells the business owner what percentage of the firm's assets are being financed with debt.

Examples:
XYZ, Inc. has $4,000,000 in its capital structure of $10,000,000. The rest of the capital structure is equity financing.

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