If you run a small business, it’s quite likely that you’ll need an external source of finance to meet your business needs, such as purchasing inventory, a piece of equipment, or hiring new employees.
In such cases, debt financing is one of the many solutions you can use to finance your business.
Often referred to as financial leverage, it provides extra working capital without giving up a portion of the ownership.
In this guide, we’ll be talking about everything you need to know about debt financing. Let’s begin!
Key Takeaways
- Banks Loans, Bond Issues, Non-Bank Cash Flow Lending, Credit Card Loans and Family Loans are the five main types of Debt Financing.
- Debt Financing is best way to retain the maximum ownership of the company.
- DF can improve your credit score, and can also help you in saving tax.
- DF is a risky thing to do & you need to have a high credit score to get it.
Debt Financing
The process of borrowing money from an external source with the promise to pay it back at the end of the loan tenure with the agreed-upon percentage of interest is known as Debt financing.
The loan could be in the form of a secured or unsecured loan, collateralized with the firm’s assets taking the loan, and the loans are given based on the valuation of those assets. 1
Read: What Is Credit Card Refinancing Vs Debt Consolidation?
How Does Debt Financing Work?
Debt financing can be structured in three forms: cash flow loan, installment loan, or revolving loan:
- Cashflow loan: In this type, you receive funds on the basis of your business revenue. To access this, the lender may access data from your business bank account or consider your recent cash flow. Merchant cash advances, invoice factoring & invoice financing are all examples of Cashflow loans.
- Installment loans: These are traditional term loans in which you receive funds in a lump sum and repay it back over a fixed period of time in installments along with the interest rate. Bank loans, bond issues, etc., are examples of installment loans.
- Revolving loan: In a revolving loan, you get access to a set amount of funds, and you can withdraw amounts from it as and when you need. You pay interest on only what you withdraw in this option. Credit cards and business lines of credit are an example of revolving loans. 2
Types Of Debt Financing
Here are the different types of DF options:
1. Banks Loans
Bank loans are the most convenient type of DF. Banks offer a wide variety of loan options and interest rates based on the financial situation and needs of each company. Bank loans usually have a term between 3 to 7 years.
2. Bond Issues
Bonds are loans taken out by individuals, companies, or organizations, and then they become creditors by loaning money to businesses in need of debt financing.
The bonds typically include a principal value, interest rate, and a repayment term of 10 to 30 years or more.
3. Non-Bank Cash Flow Lending
Non-bank cash flow lending is an unsecured loan often used by businesses to finance the working capital of day-to-day operations such as payroll, rent, and inventory.
These loans are flexible and can be paid as a fixed amount over a specified period or as a percentage of sales you make until the principal amount is paid off.
4. Credit Card Loans
Borrowing through a credit card is another type of debt financing in which you can get funds from a lender at a specified interest rate, monthly installments, and repayment based on your credit score.
5. Family Loans
Another form of Debt Financing is borrowing money from family and friends through credit cards.
These are personal loans, where the borrower or the lender tracks the interest due and repayment schedules.
6. Business Term Loans
This one is a very standard way of debt financing. A business term loan works just like a mortgage or car loan.
In this, you take money in lump sum amounts and pay it with interest over a set period of time. Business term loans are best for business expansion or renovation.
7. Business Lines of Credit
In a business line of credit, you get access to funds that you can withdraw anytime.
You pay interest only on the number of funds you withdraw. And in most cases, once you repay the amount borrowed, the credit line resets to the initial limit.
This type of debt financing is one of the most flexible methods, and it is best suited for financing the gaps between funds, operating costs, etc.
8. SBA
Small-business loans or SBAs are issued by participating lenders such as credit unions and banks and are partially guaranteed by U.S. Small Business Administration.
The partial guarantee helps reduce lenders’ risk and also acts as an incentive for them to work with small businesses.
In this, the SBA set the guidelines regarding repayment terms, interest rates, etc. SBA is perfect for business expansion, working capital needs, etc.
9. Invoice factoring & Invoice Financing
Invoice factoring means selling your invoices to a factoring company at a discounted rate. And invoice financing means borrowing money against outstanding invoices from a lender.
Both of these forms of debt financing allow you to access finances by using your unpaid invoices.
This method is suitable for those businesses that face day-to-day cash flow issues due to unpaid customer invoices.
10. Merchant cash advance
In this type of debt financing, a company offers you lump sum money that you have to repay using your credit or debit card, including fees.
Meanwhile, until you have repaid the MCA in full, it will keep deducting a weekly or daily percentage of your sales.
MCA is the most expensive type of debt financing, with interest rates going as high as 350% yearly, so we do not recommend it. 3
Short Term Vs. Long Term Debt Financing
A short term debt financing is required by a business to fund the day-to-day business expenses such as the working capital, wages, inventory, maintenance of supplies, etc.
This type of debt financing lasts for a year usually. Some examples of short-term debt financing options are lines of credit, non-bank cash flow lending, etc.
Long-term debt financing is opted for by businesses that are looking to expand their business and want to purchase a new building, machines, etc.
Long-term debt financing is usually secured by collateral, and the repayment period, in this case, lasts for up to ten years.
Some examples of long-term financing include business term loans, bond issues, bank loans, etc.
Pros & Cons Of Debt Financing
Here are some major pros and cons that you must consider before taking out any finances from an external source:
Pros
- Debt financing is an easy and accessible option for businesses of all sizes.
- It is the best way to retain the maximum ownership of the company.
- The payments are tax-deductible, which decreases the company’s tax obligations and interest rates.
- Regular monthly payments improve your credit scores enabling you to access more funds in the future.
Cons
- You must have a good credit rating to get qualified.
- Also, you have to put some of your business assets at potential risk.
- You must be financially disciplined to make all your repayments on time. 4
Debt Financing Vs. Equity Financing: Explained by Reddit Users
Debt financing vs Equity financing
by u/xcsob in startup
How To Choose The Best Debt Financing Option?
In order to choose the best debt financing option, here are some questions that you should ask yourself:
- For what purpose do you need funding?
- How much amount do you need?
- What is the limit of debt that you can afford?
- How much flexibility do you need?
- How much interest rate can you afford to pay?
- What is your business qualification? (annual revenue, credit score, etc.)
- How fast do you need the funding? 5
Wrapping Up
So debt financing is a great way for businesses to fund their short-term expenses, such as operating costs, working capital, etc., and also their long-term expenses, such as purchasing land or assets.
In this guide on What debt financing is, we revealed the meaning of the terms, shared its pros and cons, and also the different types of DF options that you can go for. Hope this was helpful.
FAQ’s
Is debt financing a good or a bad option?
Debt financing can be good and bad, depending on how you use it. If you are using it to fund the growth of your company, then it is a good option.
What is the difference between debt and equity financing?
In debt financing, you raise money from lenders and repay them back the amount borrowed along with interest.
In equity financing, however, you raise funds by selling partial ownership or equity to the investing company.
Is debt financing a loan?
On the contrary, loan is a type of debt financing.
Amit Gupta is the founder of National Planning Cycles, a company that helps startups, individuals, and small businesses with their financial planning. He has a vast amount of experience in the finance sector, having managed Google Play accounts for some of the world’s most successful unicorns. Amit is an expert in his field, and he uses his knowledge to help others achieve their individual goals.
ARTICLE SOURCES
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- https://www.nerdwallet.com/article/small-business/debt-financing#:~:text=Debt%20financing%20is%20when%20you,partial%20ownership%20in%20your%20company.[↩]
- https://corporatefinanceinstitute.com/resources/commercial-lending/debt-financing/[↩]
- https://www.nerdwallet.com/article/small-business/debt-financing[↩]
- https://www.americanexpress.com/en-us/business/blueprint/resource-center/finance/pros-and-cons-of-debt-financing/[↩]