The basic accounting equation states that assets equal liabilities plus owners’ equity. This equation remains constant because firms look to debt, also known as liabilities, or investor money, also known as owners’ equity, to run operations. Now lets discuss some of the characteristics of debt financing. Debt financing is long-term borrowing provided by non-owners, meaning individuals or other firms that do not have an ownership stake in the company. Debt financing commonly takes the form of taking out loans and selling corporate bonds. For information on bonds select the link above to access the video: How Bonds Work. Using debt financing provides several benefits to firms. First, interest payments are tax-deductible. Just like the interest on a mortgage loan is tax-deductible for homeowners, firms can reduce their taxable income if they pay interest on loans. Although deduction does not entirely offset the interest payments it at least lessens the financial impact of raising money through debt financing.
Another benefit to debt financing is that firm’s utilizing this form of financing are not required to publicly disclose of their plans as a condition of funding. The allows firms to maintain some degree of secrecy so that competitors are not made away of their future plans. The last benefit of debt financing that we’ll discuss is that it avoids what is referred to as the dilution of ownership. We’ll talk more about the dilution of ownership when we discuss equity financing.