What are the downsides of debt financing?

The most crucial aspect when analyzing debt financing is the internal rate of return of our business. Ultimately, what we achieve is the spread between our operating margin and the interest required to finance our operations. Debt payments do not necessarily increase if interest rates rise. We have the option to decide whether to lock in a fixed rate with reset dates or renegotiate debt covenants. Even with variable debt, depending on the company's financial sophistication, there are instruments available to hedge against rate volatility.

Interest is the cost of borrowing money, which adds up over time. This can become a significant financial burden and impact the business's profitability. It's crucial to factor in these costs when considering debt financing.

While debt financing offers access to capital, it comes with repayment obligations that can strain flexibility and liquidity. However, proactive management can mitigate these downsides. Establish a comprehensive repayment plan aligned with cash flow projections to ensure timely payments. Maintain open communication with creditors to negotiate favorable terms and address any challenges. Diversify funding sources to reduce dependency on debt and enhance financial resilience. By adopting strategic debt management practices, businesses can navigate repayment obligations effectively, preserve reputation, and sustain financial health, maximizing the benefits of debt financing while minimizing its drawbacks.

You are legally bound to repay the borrowed amount with interest, regardless of your financial situation. This can put a strain on your cash flow, especially if your income fluctuates or unexpected expenses arise.

Debt financing comes with an obligation to repay said debts in predetermined installments. The company must ensure sufficient liquidity to be able to do so. Being unable to repay debts can lead a company to a default, insolvency, and/or bankruptcy, among other consequences. In this case, debt owners must be paid before equity owners.

The interest rate and amortization (repayment) schedule tend to receive the most focus in negotiations between a borrower and lender but the covenants tend to the area in the loan agreement that gets borrowers in trouble first/fastest. Most loan agreements in this environment have financial performance and balance sheet test covenants so it's critical to understand: - The measurement period - The measurement itself (e.g., how is EBITDA defined) - The opportunity and time period to cure a trip - The consequences of 'busting' a covenant A great interest rate is useless if the borrower trips a covenant early in the loan. Borrowers should target a set of covenants with which they are highly confident they can comply.

Debt is a double edged sword. Used effectively, it can propel a company (borrower) to new heights But it's not without risk, macroeconomic downturns, personnel risks, interest rate shocks etc are enough to severely impact the ability of a borrower to stay current on their debt

From experience- Few but important downsides of debt financing are- 1. The borrower has to pay Interest from day one unless he can negotiate a moratorium, which generally depends on a couple of factors, some of which may not be in control of the borrower. 2. The fixed & current assets of the borrower (Including his personal assets !) may be stuck as collaterals with the lender, which in turn could put some harsh penalties on the borrower. 3. Often times a lender may not even allow prepayment as it may mess up his Asset-Liability Management. This negatively impacts the borrower with extended periods of interest.