Meaning of Debt Financing Part II

Debt Financing 2

Why is debt financing important to your business?

The main advantages of external financing for your company lie in the possibility of making new investments . If new machines, vehicles or even an extension of the production facility are necessary to increase productivity and thus sales , you can put your project into practice with the appropriate loans. At the same time, you retain the power of determination, because lenders have no influence whatsoever on the management of your company. A profit distribution to the creditor is not necessary.

What are your goals with external financing?

The aim of external financing is usually to increase the company’s internal financial resources in order to be able to make the necessary investments. The equity of a company remains untouched, so that profitability is maintained or improved. At the same time, you can reduce the tax burden by paying interest.

External financing in comparison

For the procurement of capital, you not only have external financing, but also internal, external and internal financing . In some cases, mixed forms can arise. For example, you can take part of the investment you need directly from your company and get the other part from external creditors.

External financing vs. self-financing – which is cheaper?

According to ACRONYMMONSTER, self-financing and leverage are two opposing ways of raising capital that need to be compared. It is important to know that debt financing can lower the tax burden through interest payments. In addition, a loan from external investors usually makes more sense over a longer period of time.

What is the difference between outside financing and outside financing?

With debt financing, the borrowed capital comes from a third-party lender who has no connection with your company. In contrast, with external financing, the source of the funds is outside the company. With external financing, for example, you can transfer the funds you need yourself from your private bank account to the business account.

How do external financing and internal financing differ?

The internal financing is the counterpart to external financing. The funds come directly from the company – it’s capital that comes from normal sales. Internal financing is divided into external financing and internal financing. Self-financing includes, for example, retained earnings.

When is it worthwhile to use self-financing as an alternative?

Self-financing is always worthwhile when external financing would cause significantly more costs than self-financing. You should note that self-financing will significantly reduce the profit distribution. In addition, self-financing should only take place if the company’s financial situation is still stable after the capital investment.

Debt Financing Risks

The risks of external financing lie primarily in the obligatory repayments. If necessary, you will no longer be able to repay your installments if the debt financing is too high. A bankruptcy proceedings threatening.

Another point of criticism is seen by many financial advisors in the danger of over-indebtedness . In the event of over-indebtedness, the outside capital can no longer be covered by the company’s internal assets.

What is meant by the debt capital ratio?

By calculating the debt capital ratio, you get an impression of how much debt capital contributes to your company’s total capital . From this you can draw conclusions about your attractiveness for new creditors. The so-called capital risk also increases as the level of external financing increases. It will be much more difficult to obtain new loans in the future.

How is the debt ratio calculated?

To calculate the debt ratio of your company, divide the short, medium and long-term loans as well as the provisions and half of the special items by the total capital of your company. To get a percentage, multiply the result by 100.


Debt capital ratio = (debt capital / total capital) x 100%

How high should the leverage ratio be?

As a general guideline, there is a maximum limit of 67 percent outside capital within a company. Depending on the industry in which you work, this value can fluctuate.


Borrowed capital is the term used to describe financial resources from external investors . Both internal and external financing can take place. The counterpart to external financing is self-financing, i.e. the raising of funds from internal funds. In some cases, a mixed form of the forms mentioned makes sense in order to obtain the cheapest and most effective financing.

It can be divided into short-term, medium -term and long-term loans, which can be given by professional institutions (banks) as well as by your suppliers and customers. As a rule, a fixed rate is agreed for repayment, which is made up of repayment and interest. You can deduct the interest to reduce the tax burden.

In a nutshell: frequently asked questions about debt financing

What is shareholder debt financing?

In the case of shareholder debt financing, a shareholder lends money to a corporation. Accordingly, he acts both as a lender and equity provider vis-à-vis the company.

What collateral does external financing require?

In order to receive outside capital, you must have a good credit rating and sufficient collateral, which should correspond to the value of the financing. These can be tangible as well as intangible assets.

Why do provisions belong to external financing?

Provisions can be seen as funds that do not belong to the company. Accordingly, you can also view it in the broadest sense as external financing that must be paid off after a certain period of time.

How should the outside financing be shown in the balance sheet?

The funds raised are booked as “liabilities” in the balance sheet in accordance with Section 266 (3) HGB .

How does leverage affect the return on equity?

The debt financing provides a leverage effect for the company. This means that as your company’s bottom line grows, your company’s profitability will improve.

What are the costs of external financing?

The debt financing is primarily associated with the so-called interest during the entire repayment period. In addition, there may be one-time loan fees and short-term commitment interest.

Debt Financing 2