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Very few startups can function without capital. It’s needed for hiring, inventory, marketing—you name it. But not all forms of capital are created equal.
Here, we will be introducing you to debt capital. We’ll be explaining what it is, and how it can be useful for your business, so that you’ll be able to make informed decisions about the type of funding you pursue.
What is Debt Capital?
Debt capital is money that is borrowed and must eventually be repaid—usually with interest. It’s a type of short-term financing, which can be useful for businesses that need money for operational costs or one-time expenses.
There are a few different types of debt financing, including:
- bank loans
- personal loans
- overdrafts
- lines of credit
Despite needing to pay back the capital, many founders will choose to acquire debt capital over equity capital, as it doesn’t dilute their ownership of the company.
Debt Capital vs. Equity Capital
With debt capital, a business takes on debt in exchange for capital. With equity capital, the business gives up equity in exchange for capital.
Equity capital can take a number of forms, including:
- Common Stock: This is the standard stock issued by the company. Investors hand over capital to the business in exchange for equity (i.e., shares).
- Preferred Stock: This is stock that grants the holder special rights—often higher dividend yields or a greater claim over assets in the event of liquidation.
- Retained Income: This is when the business reinvest profits back into the company, rather than distributing them to shareholders.
Both debt and equity financing have their own advantages and disadvantages, which we’ve detailed below.
Advantages of Debt Capital
The main advantage of debt capital is that it doesn’t dilute the ownership of the company. This is because, with debt financing, the business is simply taking on a loan—it isn’t selling equity.
Another advantage of debt capital is that it’s often easier to obtain than equity financing. Equity financing is more difficult to obtain because investors will only want to invest in companies that they believe have high growth potential. This means that businesses often need to be more established to obtain equity financing.
Disadvantages of Debt Capital
The main disadvantage of debt capital is that it needs to be repaid—usually with interest. This can put a strain on the business, especially if it isn’t generating enough revenue to cover the repayments.
Another disadvantage of debt capital is that it can limit the growth of the business. This is because the business will need to use a portion of its revenue to make repayments, which could otherwise be reinvested back into the business.
Debt to Capital Ratio Explained
A debt-to-capital ratio defines a business’ financial leverage. Essentially, it describes the proportion of interest-bearing company debt and all liabilities (all debt) against the total of the debt and shareholder’s equity. The higher the debt to capital ratio, the riskier it is to invest in the company.
Formula to work out the debt to capital ratio:
Is this the same as the debt to total capital ratio?
Yes, the formula for debt to total capital ratio is the same as the debt to capital ratio.
Capital Without Diluting Equity
Debt capital can help founders and business owners cover their operational expenses without diluting their ownership or decision-making power. There are tons of kinds of debt capital you can seek out, but be wary of predatory terms—debt capital always needs to be repaid in-full!
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