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Borrowed capital, also known as debt capital, is money that is borrowed from others, either individuals or banks, to make an investment.
In return, the borrower is obligated to repay the capital with interest no matter what the returns of the company are. It is an important component in determining the weighted average cost of capital (WACC) for a company. This may include money borrowed to pay for things like salaries, equipment, or other expenses. It differs from equity capital, which is owned by the company and its shareholders.
Borrowed capital is normally a secured loan in the form of bonds, business loan, mortgage, etc., thereby in financial parlance, it is also called as debt capital. Being classified as debt, there is a business obligation to pay the debt and its payment is prioritized above any equity payments.
Borrowed capital can take the form of loans, credit cards, overdraft agreements, and the issuance of debt, such as bonds. Most of these funds are charged an interest rate calculated based on the amount of the borrowed capital. At times, a company may choose to keep some of the money they make instead of paying it out to shareholders as dividends, and this money can also be used as borrowed capital to help the company operate.
Borrowed capital is also referred to as “loan capital” and can be used to grow profits, but it can also result in a loss of the lender’s money. According to a Congressional Research Service report from 2019, almost 80% of small businesses in the U.S. relied on borrowed capital to operate their businesses. In 2018, small business loans amounted to $632.5 billion.
Let’s take some examples to understand borrowed capital:
Example 1: When a person buys a home, they typically make a down payment. The down payment comes out of their wealth, their savings, or proceeds from the sale of another house. If a home costs $300,000, their down payment would be $60,000, which is a 20% down payment, standard in the United States. The remaining cost of the house, $240,000 ($300,000-$60,000), would need to be borrowed.
The additional funds needed to purchase the house would come in the form of a mortgage loan from a bank. So, the house, which is now an asset belonging to the homeowner, is acquired with both equity and debt or borrowed capital, in the form of a mortgage. The cost to borrow the $240,000 would come with a monthly interest rate that the homeowner would need to pay in addition to the principal installments of paying back the loan.
Example 2: A company needs to purchase new equipment to expand its operations, but it doesn’t have enough cash on hand to make the purchase. The company decides to borrow money from a bank to finance the purchase of the equipment. This borrowed money is considered borrowed capital.
Example 3: A corporation declares a cash dividend to its shareholders, but instead of paying out the dividend, the corporation decides to temporarily retain the funds to provide operating funds. This retained cash is considered borrowed capital.
Such examples describe how borrowed capital can be used to finance a company’s operations or provide temporary funding.
Below we’ve listed the sources from where you can borrow the money for your expenses:
Generally, loans are the most common form of borrowed funds. Many public and private institutions are providing loans at fixed rates. Loans are secured by charging the borrower’s assets.
Debentures are of many types. Usually, they have one thing in common – they are charged with a fixed rate of interest that a company is entitled to pay regularly, irrespective of the company’s profits or losses. Most are secured by charging the assets, and some remain unsecured but for a higher interest rate.
These deposits are accepted by the public, usually on a larger scale. They do not create any charge on the company’s assets and also meet the short-term and medium-term needs of the company.
Many nationalized and general banks offer timely assistance to borrowers by providing them with the funds required. Here, too, they are entitled to fixed interest and are mostly secured by charging the borrower’s assets.
A fixed-interest loan is issued by the borrower; these are instruments that are generally financed by the public when a company or the government wants to raise capital from the public. A fixed interest-bearing instrument, this type of borrowed capital can prove to be a very safe investment option for the public to invest in.
Other sources, like personal savings, business loans, angel investors, friends, and family, are the resources of borrowed funds classified into long-term, medium-term, and short-term resources, respectively.
Some debt investors are only interested in principal protection, while others need a return in the form of interest. The rate of interest is determined by market rates and the creditworthiness of the borrower. If there’s a higher rate of interest, it helps to compensate the borrower for the increased risk. In addition to paying interest, debt financing often requires the borrower to adhere to certain rules regarding financial performance. These rules are referred to as covenants.
Debt financing can be difficult to obtain. However, for many companies, it provides funding at lower rates than equity financing, particularly in periods of historically low interest rates. The interest you pay on debt is tax-deductible. As a result you don’t have to pay any tax on the borrowed amount. Still, adding too much debt can increase the cost of capital, which reduces the present value of the company.
There are two types of financing available to a company when it needs to raise capital: equity financing and debt financing. Debt is money that is borrowed from financial institutions, individuals, or the bond market. Equity is money the company already has in its coffers or can raise from would-be owners or investors. The term “borrowed capital” is used to distinguish capital acquired with debt from capital acquired with equity.
Debt financing involves borrowing money from different sources like financial institutions or individuals and paying it back with interest. They are cheaper and lower-risk alternatives for getting finances as compared to equity capital.
Once you pay the loan back, the lender has no control over your business. Also, it is easy to forecast your expenses because loan payments do not fluctuate.
Debt Capital is of three types:
Debt financing includes bank loans, loans from family and friends, government-backed loans such as SBA loans, lines of credit, credit cards, mortgages, and equipment loans.
Equity Capital is the total amount of funds invested by the owners in their business. The equity of a company gets divided into several units, and each unit is called a share. The owners can sell some of these shares to the general public to raise funds. There are two types of shares: Equity Shares and Preference Shares. In Equity financing, there is no obligation to repay the money acquired through it and no requirement for monthly payments.
Let’s suppose company ABC is looking to expand its business by building new factories and purchasing new equipment. It will be done through a combination of equity financing and debt financing.
For the equity financing component, it sells a 15% equity stake in its business to a private investor in return for $20 million in capital. For the debt financing component, it obtains a business loan from a bank for $30 million, with an interest rate of 3%. The loan must be paid back in three years.
There can be many different scenarios with the above example that would result in different outcomes. For example, if Company ABC decided to raise capital with just equity financing, the owners would have to give up more ownership, reducing its share of future profits and decision-making power.
Conversely, if Company ABC decided to use only debt financing, its monthly expenses would be higher, leaving less cash on hand to use for other purposes, as well as a larger debt burden that it would have to pay back with interest.
| Debt Capital | Equity Capital |
| Debt Capital is borrowing money from individuals and organizations for a fixed tenure. | Equity capital is the funds raised by the company in exchange for the ownership rights of the investors. |
| Debt Capital is a liability for the company that they have to pay back with interest. | Equity capital is an asset for the company that is shown in the books as the entity’s funds. |
| Debt Capital is a short-term loan for the organization. | Equity Capital is a relatively longer-term fund for the company. |
| A debt financier is a creditor for the organization. | A shareholder is the owner of the company. |
| Debt Capital is a low-risk investment. | Equity Capital is a high-risk investment. |
| The lender of Debt Capital gets interest income along with the principal amount. | Shareholders get dividends/profits on their shares. |
| Debt Capital is either secured (against the surety of an asset) or unsecured. | Equity Capital is unsecured since the shareholders have ownership rights. |
Debt financing can be in the form of instalment loans, revolving loans, and cash-flow loans. Installment loans have set repayment terms and monthly payments. These loans are basically of two types: Secured or Unsecured.
Revolving loans provide access to an ongoing line of credit that a borrower can use, repay, and repeat. Credit cards are an example of revolving loans.
Cash flow loans provide a lump-sum payment from the lender. Payments on the loan are made as the borrower earns the revenue used to secure the loan. Merchant cash advances and invoice financing are examples of cash-flow loans.
Below is a list of the more common types of debt financing.
Let’s have a look:
Note: Some options may be harder for small businesses to secure, especially if they haven’t been in operations for long or if their financial position is not as strong as larger companies.
| Types of Debt Capital | Description |
| Lines of Credit | A line of credit is a flexible loan that provides businesses with access to a specific amount of capital that can be drawn upon as needed. Lines of credit are particularly useful for managing cash flow, covering short-term operational expenses, and addressing unexpected costs. |
| Revolving Credit | Revolving credit facilities function much like lines of credit but are typically larger and used by more substantial businesses. These facilities provide a pool of capital that the business can draw from and repay multiple times (but not to exceed a credit limit of up to a certain amount). |
| Trade Credit | Trade credit is a form of short-term financing extended by suppliers. It’s when a company can buy something and then pay 30 or 60 days later. This type of financing helps businesses manage inventory and produce the goods they need for their businesses. |
| Equipment Financing | Equipment financing involves borrowing funds specifically to purchase business-critical equipment, with the equipment itself serving as collateral. This type of loan or lease allows businesses to acquire machinery, vehicles, technology, and other assets necessary for operations without the immediate cash outlay. |
| Term Loans | Term loans include borrowing a lump sum of capital from a bank or financial institution that must be repaid over a predetermined period. It may have fixed or variable interest rates. These loans are usually structured with regular monthly payments that include both principal and interest. |
| Merchant Cash Advances | Merchant cash advances provide businesses with a lump sum payment in exchange for a percentage of future credit card sales. This type of financing is popular among businesses with high credit card transaction volumes that need cash now. However, merchant cash advances can come with higher costs compared to traditional loans. |
| Convertible Debt | Convertible debt is a hybrid form of financing where loans can be converted into equity shares in the company after a fixed date. A company can choose to issue a bond but give the holder the option of switching from debt financing to equity financing later. |
Trading on equity, also known as financial leverage, is a strategy that involves taking on debt such as bonds, debentures, loans, or preferred stocks to generate higher profits than the cost of the borrowed funds. The company then uses these funds to purchase assets, which will generate returns for the shareholders on their investment and help them to earn more revenue.
Companies apply this method of financing when they believe the assets will produce more profits than the borrowed principal and interest amount paid on the debt. This financial process increases equity shareholders’ wealth. As a result, the value of the shares rises. They usually go this way to boost earnings per share (EPS).
Let’s take a quick example to better understand this unique financial concept:
A company has borrowed 90 crore as debt funds with an 8% interest rate. Later, they used the borrowed money to buy an asset (factory) to generate more income. The interest needed to be paid on the loan was around Rs.10 crores, while the income generated from the asset amounts to Rs.30 crores.
In this situation, the company successfully used the trading on equity strategy with the help of its revenue-generating capacity. They’re not only covering the interest expenses but also making significant profits. This showcases the effectiveness of the Trading on Equity approach.
Trading on equity can be classified into two types – trading on thin equity and trading on thick equity. Here’s a closer look at each of these two types.
If the debt capital of a company is higher than its equity capital, it is considered trading on thin equity. For instance, if the borrowed funds are ₹90 crores and its equity share capital is ₹35 crores, then the company is said to be trading on thin equity.
In trading on thick equity, a company borrows a small amount close to the company’s equity as the company’s equity capital is more than the debt capital. For example, if the company’s equity capital amount is Rs.300 crores whereas the debt capital amount is Rs.100 crores, then the company is said to be trading on thick equity.
A company that uses the trading on equity strategy has a host of different benefits.
Here’s a list:
The primary purpose of the trading on equity strategy is to enable companies to generate more revenue for shareholders. When executed correctly, a company can significantly enhance its revenues, profits, and, ultimately, returns to investors.
Interest payments over debt are tax-deductible, providing a tax shield that reduces the overall tax liability of the company. This effectively means that the company can lower its total taxable income by claiming the interest paid on the borrowed amount as a deduction. This will help lower the amount of taxes that it has to pay to the government and further enhance the company’s net income.
Trading on Equity allows a company to leverage its existing equity base to access additional funds. This can be useful for growth-oriented companies that may have limited internal resources for expansion.
For companies, there are two types of funding options available – equity financing and debt financing. Equity financing involves the issue of equity shares to the public in exchange for funds. This method of financing may be more cost-effective than debt, it will dilute the ownership and control of the company since it will lead to more equity shares in circulation.
However, Debt financing will not cause any such dilution of ownership. The company will get to retain control over its business operations as it is. This is one of the primary reasons why trading on equity is widely preferred.
Trading on equity refers to the use of borrowed funds to increase the potential return on equity. This practice involves taking on debt to acquire more assets, aiming to generate higher profits for shareholders. It focuses on the difference between returns on investments and interest on debts.
On the other hand, equity trading involves buying and selling shares of a company on the stock market. Traders invest in company stocks to gain profit from price fluctuations in equities. Many companies prefer to use this strategy over the trading on equity method to raise the Earnings Per Share (EPS) of their shares. Unlike trading on equity, equity trading does not involve borrowing funds. Rather, it revolves around the dynamic activity of buying and selling stocks in the market to achieve financial gains.
Borrowed capital is money that a company raises through borrowing from individuals or institutions, and they must repay the entire amount after a specific time interval. The most common form of borrowed capital is a loan. It allows the lender to sell that asset and recover its money if it does not repay within a fixed duration. For instance, if you take out a small business loan and you turn no profit, you still need to pay back the loan plus interest, known as borrowed capital.
