Debt Financing: Types and Sources
Why do companies use debt in the first place?
The short answer: leverage amplifies the equity investor’s return — as you’ll see in detail in the upcoming WACC and leverage lesson. Investors who fund large acquisitions (like LBO funds) rely specifically on debt to achieve much higher returns on the equity portion they contribute.
Debt capacity
Before any lender agrees to finance a company, it measures repayment ability from several angles:
| Category | Indicators |
|---|---|
| General measures | EBITDA level, EBITDA stability over time, capital expenditure, cyclicality, competitive intensity |
| Balance sheet measures | Debt-to-equity, debt-to-total-capital, debt-to-assets |
| Cash flow measures | Total debt ÷ EBITDA, senior debt ÷ EBITDA, net debt ÷ EBITDA, interest coverage ratio ((EBITDA − Capex) ÷ Interest) |
Senior Debt
The highest priority in repayment, and usually the lowest cost. The most common types:
- Revolver: a revolving line of credit from a bank — draw and repay as your liquidity needs shift, like a corporate credit card.
- Term Loans: a fixed repayment schedule (amortizing plus a final principal repayment), and can be stacked on top of each other.
Senior debt typically provides 2x to 3x EBITDA of capacity, requires at least 2x interest coverage, and is usually provided by commercial banks, credit companies, and insurance companies.
Subordinated Debt
Fills the “funding gap” between senior debt and equity — higher risk and cost than senior debt, but lower than equity:
- High Yield Bonds
- Mezzanine financing (warrantless / warranted)
- PIK Notes (Payment-in-Kind) — interest accrues as additional debt instead of being paid in cash
- Vendor Notes — financing provided by the seller itself as part of a sale transaction
Credit Ratings
Rating agencies (Moody’s, S&P, Fitch) classify debt by risk:
| Category | Characteristics |
|---|---|
| Investment Grade | Low risk, low return, lower borrowing cost |
| High Yield | Higher risk, higher return, higher borrowing cost |
Debt repayment profiles
Debt isn’t always repaid the same way:
- Equal Amortizing: equal installments across the loan’s life.
- Balloon repayment: small installments, with one large payment at the end.
- Bullet repayment: the entire principal is repaid in a single payment at maturity.
The debt-vs-equity trade-off
| Equity | Debt | |
|---|---|---|
| Pros for the company | No maturity date, no interest or mandatory payments, maximum operational flexibility | Lower cost than equity, preserves founder ownership (no dilution) |
| Cons for the company | High implied cost of capital, investors expect a high rate of return | Interest payments and a (usually) fixed repayment schedule, operational restrictions (covenants) |
| In liquidation | Last claim on company assets | Higher-priority claim on assets |
The debt-versus-equity decision isn’t black and white — it’s an ongoing trade-off that shifts with a company’s life cycle stage (as you saw in the business life cycle lesson) and market conditions. Next up: how a company balances both sources to reach the lowest possible cost of capital — through WACC.