How Debt Financing Works

1. What is Debt Financing?

In simple terms, debt financing functions just like a loan. The acquirer takes on debt to fund an acquisition (usually from a bank or investor) and repays with interest over time. As mentioned, the acquirer will often repay the debt using the target company's cash flow.

Debt Financing is often used in different ways (and in conjunction with other methods) to raise capital. Generally speaking, acquisitions are made with a mixture of debt and equity; it is rare for lenders to take the risk on a deal which is financed 100% through debt.

Leveraged Buyouts

A leveraged buyout is an important piece of terminology. It simply refers to an acquisition where a buyer uses a significant amount of debt to cover the purchase price - often secured by the assets of the target country. This is common in private equity transactions where the acquirer seeks to improve the target company's operations and eventually sell it for a profit, paying off the debt in the process.

2. Debt vs. Equity Financing

Equity Financing involves raising capital by selling ownership stakes in the business - either to private investors, venture capitalists, or through public stock offerings. This avoids the need for repayments, of course - but in turn, dilutes the buyer's ownership (and hence, their decision-making power) as investors will expect a share of the profits and may have a say in company operations.

In most acquisitions, a blend of debt and equity financing is used to strike a balance between the financial obligations of debt financing and the constraints associated with equity financing.

3. Types of Debt Financing for Acquisitions

There are several types of debt financing, each with their own structure, benefits and risks. Figuring out which option is right for you as an acquisition investor depends on plenty of factors - the size of the acquisition, your financial standing and the assets of the target company, to name but a few.

Here are some of the most common types of debt financing; a combination may be used, and can be combined with equity financing.

Bank Loans (Traditional Debt Financing)

The most common method of acquisition financing is a trip to the bank. Banks may offer a simple term loan - a fixed-sum used to purchase the target company. The acquirer will then make regular repayments over a set period - typically secured by the acquired company's assets or the buyer's personal collateral.

Borrowing with the bank brings the benefits of competitive interest rates and long repayment terms - however strict lending requirements, credit checks and a lengthy approval process may be off-putting for investors.

Private Debt and Alternative Lenders

Debt is also provided by non-bank lenders such as private equity firms, hedge funds and direct lending companies. Often they will take on more risk and provide more flexibility than the banks. If you are looking for a faster approval process with less stringent requirements, this may be preferable.

With that said, there is of course a trade-off; often, repayment terms are shorter and interest rates will of course be higher if you opt for a non-bank lender.

Seller-Based Financing

Particularly for small or medium sized deals, a seller may agree to finance part of the deal - allowing the buyer to pay repayments over time. Generally this is more common in deals of such size because traditional financing may be harder to obtain.

A seller who is prepared to offer financing options may be more flexible than a traditional lender - they obviously have intimate knowledge of their company (the target company). Being prepared to finance the deal shows their confidence in the future of the company being sold.

Generally speaking, Seller-Based financing usually covers part of the purchase price and the interest will likely be higher than traditional financing. Sellers may also impose restrictions on business operations.

4. How Deals are Structured

Already we've mentioned that it is rare for an acquisition to be financed 100% through debt. This is for obvious reasons - lenders prefer buyers to invest equity because it reduces the chance of default. Future cash flow issues could potentially mean that the acquirer struggles to make future repayments if the company starts to struggle.

Therefore, deals are likely to balance different sources of funds. The right structure balances leverage, repayment terms, and financial flexibility; it should not overburden the acquirer or the target company.

When deciding how to structure debt financing, buyers should assess their risk tolerance, cash flow capabilities, and long-term financial strategy. A well-structured deal ensures that debt enhances returns rather than creating financial strain.

What is Loan-To-Value (LTV) Ratio?

The Loan-To-Value ratio measures how much debt is used compared to the total price of the acquisition. We calculate it by dividing the amount borrowed to purchase the company by the value of the transaction; for example, if you purchased a company for £10 million and financed half of the transaction (£5 million) from debt, your LTV ratio is 50%.

The higher the LTV, the more debt that a buyer is using to fund an acquisition; an LTV of 100% therefore means that the buyer is paying for the target company entirely using debt financing.

Down Payments and Cash Reserves

Usually lenders will require a down payment, which reduces their risk whilst reinforcing the buyers financial commitment. Typically it will range from 10% to 30% of the total acquisition cost. Similarly, buyers are expected to maintain cash reserves to cover unexpected expenses, loan payments and operational needs post-acquisition.

Covenants

Debt agreements often include covenants—conditions set by lenders to ensure financial stability. These can include:

• Financial Covenants: Maintaining specific financial ratios (e.g., Debt-to-EBITDA, Interest Coverage Ratio).
• Operational Covenants: Restrictions on major business decisions (e.g., dividend payments, new debt issuance).
• Performance Covenants: Requirements related to revenue or profitability targets.

Repayment Terms

Repayment terms vary based on the type of debt. Long-term loans offer lower monthly payments but higher overall interest costs, while short-term financing requires quicker repayment but may reduce total interest expenses. Structuring the right repayment plan ensures the business can handle debt service without straining cash flow.

A well-structured debt financing plan balances risk, flexibility, and long-term business sustainability. Careful consideration of these factors can make the difference between a smooth acquisition and financial distress.

5. The Pros and Cons of Debt Financing

Debt financing is undoubtedly a powerful tool for investors acquiring a company. We already noted that it is generally used alongside other methods of financing to complete a deal. Debt financing allows buyers to complete a transaction without diluting equity, but it also comes with financial obligations.

Advantages

Preserving Ownership Equity. Leveraging debt allows a buyer to retain full ownership (and therefore, control) of the target company - unlike equity financing, which gives investors a stake of the company in exchange for their funding contribution. For many buyers, maintaining decision-making power is the most important reason to choose debt financing over equity financing.

Bigger Purchasing Power. Of course, Debt Financing allows buyers to leverage borrowed capital - therefore acquiring a larger or more profitable business than they could afford with cash alone. If the acquired company generates strong returns, the use of leverage (i.e. debt financing) can significantly boost the buyer's return on investment (ROI).

Tax Benefits (Interest Deductibility). In the UK, interest payments on business loans are tax-deductible, whereas dividends paid to shareholders are not. This makes debt financing more tax-efficient than equity financing for many businesses.

Disadvantages

Increased Financial Risk. All borrowing comes with risk. High levels of debt can make the company vulnerable to economic downturns, interest rate fluctuations, or unexpected expenses - anything that could cause dips in performance post-acquisition could lead to financial strain.

Cash Flow Constraints. Of course debt financing requires regular repayments - which can place strain on the cash flow of a company, particularly just after an acquisition. If for some reason the acquired company's revenue is inconsistent or lower than expected, meeting debt obligations can become a challenge.

Restrictive Covenants. Having to meet the conditions set by the lender may hamper a buyer's ability to freely run their newly acquired business as they see fit.

6. Key Metrics Guide

If you plan on using debt to finance an acquisition then you'll need to evaluate whether the target company can service the debt without it causing financial strain.

The following financial ratios help both buyers and lenders assess the company's ability to handle debt payments whilst maintaining profitability.

Debt Service Coverage Ratio (DSCR)

This measures a company's ability to cover its debt obligations with its operating income. The calculation is simple: divide net operating income by total debt service (which includes interest and principal).

If the operating income is greater than the total debt, then this figure will be greater than one. A DSCR of 1.25 or greater is usually considered healthy (i.e. when net operating income is at least 1.25x total debt service) - this shows that the company can comfortably bear the cost of the debt.

A DSCR of 1.0 would suggest that a company has barely enough income to cover debt obligations, leaving little or no room for unexpected costs.

A DSCR of less than 1.0 would be considered a high risk scenario as the income of the company is not sufficient to even meet the debt obligations.

Lenders typically require a DSCR of 1.25 - 1.50 in order to approve financing, which ensures the company has a buffer for unforeseen circumstances that may arise.

Interest Coverage Ratio

The Interest Coverage Ratio explains how easily a company can repay the interest payments on the debt that it has outstanding.

To calculate the figure, you divide the company EBIT (earnings before interest and taxes) by the Interest Expense. Effectively, you are determining how easily a company could repay all of its outstanding interest using its earnings - giving buyers and lenders an idea of how well the company can meet payment obligations.

A high ICR of 3.0 or more generally suggests that a company has strong earnings compared to its debt and can comfortably cover interest repayments. A low ICR of less than 1.5 signals financial distress, indicating potential difficulties in meeting debt obligations.

For buyers, the ICR helps analyse the financial position of the company - as well as determining how much additional debt can sensibly be loaded onto the company. This is of course important for buyers who are using debt to finance their acquisition.

Leverage Ratio

A company's Leverage Ratio is often expressed as their Debt-to-EBITDA. To calculate it, we simply divide the total debt of a target company by its EBITDA.

Debt in this case includes all interest-bearing obligations (such as bank loans, corporate bonds, lines of credit) - it does not include operational liabilities like accounts payable. EBITDA is used as a proxy for cash flow because it measures earnings before non-cash expenses like depreciation.

A high Leverage Ratio (for example, 5.0 or more) suggests excessive debt and potential problems meeting obligations - whereas a figure or 3.0 or less indicates financial stability. Like the ICR, lenders and buyers will use this to understand the financial position of the

7. Using Debt Effectively

Debt financing can be a powerful tool for acquiring a business, but if not managed properly, it can lead to financial distress. As a buyer, you want to avoid some of the common traps that may jeopardize acquisitions.

Avoid Overleveraging

One of the biggest mistakes that buyers make is borrowing too much relative to a company's financial capacity, thus overloading it with debt. Debt can amplify returns for the acquirer but excessive leverage can of course increase the risk of default - particularly if projections don't materialise and things go wrong.

To avoid this, you should use the Leverage Ratio (Debt to EBITDA) and Debt Service Coverage Ratio (DSCR) to ensure your debt is manageable. You should always stress-test financial models and could consider a mixture of debt to equity when financing an acquisition.

Understand Cash Flow Needs

Acquirers often focus on financing the purchase price, but forget to account for the post-acquisition working capital needs, operating expenses and unexpected costs. You should perform a cash flow analysis before acquisition, particularly if leveraging debt financing, to project post-acquisition expenses (including payroll, supplier payments, and loan servicing).

Plan for Economic Downturns

It's tempting during an acquisition to base your numbers on optimistic growth projections. Economic downturns, industry disruptions, or unexpected crises can impact cash flow and debt repayment ability - so not planning for downturns may face financial strain.

8. Final Notes on How Debt Financing Works