What is Debt Financing?

What is Debt Financing?

Debt financing occurs when a company raises money by selling debt instruments, most commonly in the form of bank loans or bonds. Such a type of financing is often referred to as financial leverage.

As a result of taking on additional debt, the company makes the promise to repay the loan and incurs the cost of interest. It can then use the borrowed money to pay for large capital expenditures or fund its working capital. In general, well-established businesses that demonstrate constant sales, solid collateral, and are profitable will rely on debt financing.

On the other hand, newly launched businesses that face uncertainty in the future or businesses with high profitability but lower credit ratings will more likely rely on equity financing.

How Debt Financing Works

When a company needs money, there are three ways to obtain financing: sell equity, take on debt, or use some hybrid of the two. Equity represents an ownership stake in the company. It gives the shareholder a claim on future earnings, but it does not need to be paid back. If the company goes bankrupt, equity holders are the last in line to receive money.

A company can choose debt financing, which entails selling fixed income products, such as bonds, bills, or notes, to investors to obtain the capital needed to grow and expand its operations. When a company issues a bond, the investors that purchase the bond are lenders who are either retail or institutional investors that provide the company with debt financing.

The amount of the investment loan—also known as the principal—must be paid back at some agreed date in the future. If the company goes bankrupt, lenders have a higher claim on any liquidated assets than shareholders.

Debt Financing Options

1. Bank loan

A common form of debt financing is a bank loan. Banks will often assess the individual financial situation of each company and offer loan sizes and interest rates accordingly.

2. Bond issues

Another form of debt financing is bond issues. A traditional bond certificate includes a principal value, a term by which repayment must be completed, and an interest rate. Individuals or entities that purchase the bond then become creditors by loaning money to the business.

3. Family and credit card loans

Other means of debt financing include taking loans from family and friends and borrowing through a credit card. They are common with start-ups and small businesses.

When Should You Use Debt Financing to Fund Your Business?

As Kenny Rogers sang in the song “The Gambler,” you need to know when to hold them and know when to fold them. And, this definitely applies to debt financing. It’s not for every business owner, and understanding when to leverage the advantages of debt financing can literally make or break your business. To determine whether it’s the right business move, there are a few important questions to ask yourself:

Will I use the funds to invest in variable or fixed costs?

When you invest in fixed costs such as office furniture or a piece of equipment, you probably won’t see direct cash returns from the funds you’ve borrowed. This can be a risky option for debt financing when you consider that your installment payments on the loan will begin soon after the money is lent.

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However, if the money will be used for variable costs such as for inventory or materials to make products you sell, the investment can result in immediate increased cash inflow.

At what stage is my business in?

When you’re just launching a venture, it can be tempting to want to get an infusion of cash to get things up and rolling. However, debt financing in the early stages of a business can be quite dangerous. Almost all businesses lose money before they start turning a profit. And, if you can’t make payments on a loan, it can hurt your business credit rating for the long-term.

As your business begins to flourish, and you have a better understanding of how much you’re truly making, debt financing becomes a more logical option. Remember – the chance of bankruptcy is highest during the first few years of a business and then it decreases the longer you’re operating.

Do my customers pay on time?

If you’re reliant on your customers to pay you on time so that you can pay your loan, you better make sure that those who buy from you are very reliable. Too often, this isn’t the case. Pay close attention to the payment habits of your customers.

It may make sense to offer financial incentives to get them to pay early. Not sure if you’re offering the right terms for your customers? Ask others in your industry such as within trade organizations or even competitors. You may be able to ask for more up front or for quicker payment depending on what the typical payment requirements are within your industry.

Am I organized enough to make regular payments?

Let’s face it! Not every business owner is a financial genius. That doesn’t necessarily mean you shouldn’t have your own business, but it might indicate that using debt financing could lead to trouble – especially if you have a habit of forgetting to make payments. If this sounds a bit like your modus operandi, it may be worth exploring other types of financing which we’ll get into next.

Debt Financing Over the Short-Term

Businesses use short-term debt financing to fund their working capital for day-to-day operations. It can include paying wages, buying inventory, or costs incurred for supplies and maintenance. The scheduled repayment for the loans is usually within a year.

A common type of short-term financing is a line of credit, which is secured with collateral. It is typically used with businesses struggling to keep a positive cash flow (expenses are higher than current revenues), such as start-ups.

Debt Financing Over the Long-Term

Businesses seek long-term debt financing to purchase assets, such as buildings, equipment, and machinery. The assets that will be purchased are usually also used to secure the loan as collateral. The scheduled repayment for the loans is usually up to 10 years, with fixed interest rates and predictable monthly payments.

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The Pros of Debt Financing

Maintain Ownership of Your Business

You might be tempted to get an angel investor for your growing business. This is definitely a way to infuse cash into it. But, you’ll need to ask yourself if you want outside interference from investors? If you prefer to call the shots for your business, it makes sense to leverage debt financing – in other words, borrowing from a bank or other type of lender and paying it back in the agreed upon timeframe.

The bank may charge you interest on what you borrow, but they’re not going to get involved with how you run your day-to-day operations.

Tax Deductions

Surprising to some, taxes are often a key consideration when pondering whether or not to use debt financing for your business. Why? In many cases, the principal and the interest payments on business loans are classified as business expenses. These can be deducted from your business income taxes. In some ways, the government is your partner in your business with a percentage ownership stake (your tax rate).

Lower Interest Rates

This is a somewhat difficult advantage of debt financing to understand, but it can actually be quite valuable. Tax deductions can affect your overall tax rate. In many cases, there can be a tax advantage to taking on debt.

For example, if your bank is charging you 10 percent interest on a business loan, and the government taxes you at a 30 percent tax rate, you can tabulate the following Take 10 percent and multiply it by (1-30 percent), which equals 7 percent.

After your tax deductions, you will pay a 7 percent interest rate instead of a 10 percent rate. It’s a win-win financial move that lets you both get the money you need to grow your business while also helping to slash your tax rate.

The Cons of Debt Financing

Paying Back the Debt

Making payments to a bank or other lender can be stress-free if you have ample revenue flowing into your business. But, what if sales are down? Or, worse yet, what if your business should fail? You’ll still be on the hook for the debt.

Business debt financing can be a risky option if your business isn’t completely on terra firma. To add insult to injury, if you are forced into bankruptcy due to a failed business, your lenders will have claim to repayment before any equity investors in your business.

High Interest Rates

Your parents may be willing to loan you some cash at a next to nothing interest rate, but don’t expect this from a traditional bank or other lender. Interest rates certainly vary on a variety of factors including your credit history and the type of loan you’re trying to obtain.

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However, even after calculating the discounted interest rate from your tax deductions, you may still be paying a high interest rate each month that cuts into your profits.

The Effect on Your Credit Rating

What you borrow does affect your credit rating. And, this effect can be negative if you’re borrowing large sums. This translates into higher interest rates and more risk on the part of lenders.

Cash Flow Difficulties

Not all businesses sell the same amount each month. In fact, most have periods of time that are busier than others. However, lenders typically expect payment on any debt financing in equal monthly installments.

This can be a real challenge that can lead to late payments or even defaults that can harm your credit over the long term. If you are not absolutely certain that you can pay back the loan, it’s not a good idea to get one!

Advantages of Debt Financing

1. Preserve company ownership

The main reason that companies choose to finance through debt rather than equity is to preserve company ownership. In equity financing, such as selling common and preferred shares, the investor retains an equity position in the business. The investor then gains shareholder voting rights, and business owners dilute their ownership.

Debt capital is provided by a lender, who is only entitled to their repayment of capital plus interest. Hence, business owners are able to retain maximum ownership of their company and end obligations to the lender once the debt is paid off.

2. Tax-deductible interest payments

Another benefit of debt financing is that the interest paid is tax-deductible. It decreases the company’s tax obligations. Furthermore, the principal payment and interest expense are fixed and known, assuming the loan is paid back at a constant rate. It allows for accurate forecasting, which makes budgeting and financial planning easier.

Disadvantages of Debt Financing

1. The need for regular income

The repayment of debt can become a struggle for some business owners. They need to ensure the business generates enough income to pay for regular installments of principal and interest.

Many lending institutions also require assets of the business to be posted as collateral for the loan, which can be seized if the business is unable to make certain payments.

2. Adverse impact on credit ratings

If borrowers lack a solid plan to pay back their debt, they face the consequences. Late or skipped payments will negatively affect their credit ratings, making it more difficult to borrow money in the future.

3. Potential bankruptcy

Agreeing to provide collateral to the lender puts their business assets at risk, and sometimes even their personal assets. Above all, they risk potential bankruptcy. If the business should fail, the debt must still be repaid.