Debt Financing: Everything You Need to Know
Debt financing is when a company raises money by taking out a loan and then repays that loan over time with interest. This is also known as borrowing on credit.7 min read
Debt Financing: What Is it?
Debt financing is when a company raises money by taking out a loan and then repays that loan over time with interest. This is also known as borrowing on credit. It can come from selling bonds, bills, or notes to lending institutions, or from private investors who are not looking to receive equity in your business.
It's good to be aware of the fact that banks often shy away from small businesses that are experiencing rapid sales growth, a temporary decline or a seasonal slump. They are not completely stable.
Debt Financing Versus Equity Financing
Debt financing is a loan that must be repaid, while equity financing is an investment of money in exchange for a stake in the company. The stake in the company is given through common shares.
When you receive money through equity financing, you are giving up a small piece of your company to an investor. This means that they may have a say in the operations of the company and will look for a future return on their investment.
With equity financing, you do not pay the lender back. They will either receive funds through the paying of dividends, or they can get their initial investment back by selling their shares in the company.
Sources of Debt Financing
Small businesses can get debt financing from several different sources.
- Private Sources
A lot of startups borrow money from friends and family. People that are close to you are much more likely to give flexible terms of repayment. They are also more willing to invest their money into a business that may not be fully developed yet.
A disadvantage is that friends and family may want to be more involved in the management or decision-making than a bank or investor may be. If you want to avoid these sort of situations, it may be best to make formal arrangements with your family before any money changes hands.
Banks are also a private source of debt financing. Large commercial banks will often have more experience in making business loans than small savings banks. Credit unions can also be a good source for business loans. Credit unions are there to assist members of a group, like employees of a company or members of a labor union. They will usually give more favorable terms than banks.
Finance companies will charge higher interest rates than banks and credit unions. They also usually want you to put assets up as collateral in addition to paying interest on the loan. This is the best option for people with poor credit ratings.
Trade credit is another type of debt financing. Trade credit is when a supplier lets a small business delay their payment on some of the products or services it buys from the supplier. Payment terms will differ between the suppliers.
Another type of debt financing is when a factor company helps small businesses to free up cash. They do this by purchasing that company's accounts receivable. Once the small business is paid their invoices they can then repay the factor company.
Similarly, leasing companies can also help small businesses to free up cash. They small business can rent different types of equipment instead of having to make a huge capital expenditure to purchase it. The payments are usually only small monthly installments and they allow the small business to upgrade the equipment quickly and easily.
- Public Sources
The state and federal governments sponsor a large number of programs that give funding to help with the formation and growth of small businesses. A lot of these programs are offered by the U.S. Small Business Administration (SBA) and involve debt financing.
The SBA helps small and startup businesses get funding from banks or other lenders by guaranteeing loans up to $750,000, to a maximum of 70-90 percent of the loan value, for only 2.75 percentage points above the prime lending rate.
In order to qualify for this type of loan guaranteed, a business owner needs to first have been turned down for a loan from regular banks and investors. They also need to show good character and an ability to run a successful business and repay loans.
Small Business Investment Companies (SBICs) are another source for public debt financing. They are government-backed companies that give direct loans or equity investments to small businesses. They are usually less risk-averse than banks, so funds are more available to startup companies. They also often are able to give technical assistance to small business borrowers.
The Economic Development Commission (EDC) is a branch of the U.S. Department of Commerce. They give loans to small businesses that show they will be able to provide more jobs in economically disadvantaged regions. In order to qualify for an EDC loan, you need to meet several conditions.
Debt Financing Repayment Terms
There are three main types of repayment terms for debt financing, long-term, intermediate, and short-term:
- Long-term debt financing is usually for purchasing assets for the company like equipment, buildings, land, or machinery. The repayment of these loans and the usefulness of the asset that you've purchased will last for more than five years.
- Intermediate debt financing loans are for medium-sized purchases and may help the company grow. They are to be paid back within three years.
- Short-term debt financing is usually for day-to-day spending. You might use a short-term loan for buying inventory, paying wages, or purchasing supplies. These loans are short-term because the repayment will take less than a year. A popular form of short-term debt financing is a credit card.
Interest Rates on Debt Financing
The interest rate you will receive on your debt financing will depend on current rates as well as your credit score. The more of a risk that the bank thinks you are, the higher the interest rate will be.
Advantages of Using Debt Financing
- Keeping control of your business. When you take out a loan for your business, the person lending the money has no say in the running of your company. You remain the decision maker and simply pay back your debt.
- Gaining tax benefits. The amount of money you pay in interest is tax deductible, therefore reducing the amount paid overall.
- You know how much you owe. When you take out the loan, the interest rate will be set and you will know from the very beginning how much money you owe. This makes future financial planning much easier.
Disadvantages of Using Debt Financing
- You need good credit. If you want to get a loan, you will need to have a good enough credit rating. Without this, debt financing may be impossible.
- You use your business as collateral. If you default on the repayment of your loan, you put your business in direct danger of being lost. You may also be asked to put your personal finances and assets up as collateral for your business, which is a very big risk.
- It can make it difficult to grow. Being locked into a loan repayment means that you have a priority to make payments every single month. This means that you may not have the money left over to grow and expand your business.
- It affects your credit rating. If your business relies too heavily on debt financing, it could negatively affect your credit and the ability to get additional loans in the future.
Secured Versus Unsecured Loans
Most loans you receive will need to be secured. Meaning, you will need to put up some type of collateral in case you cannot repay the loan. If you default on the loan, the lender will take your collateral as repayment.
There are several ways you can secure a loan:
- Guarantors: You can have someone else with a better credit rating or more assets sign an agreement stating they will pay the loan in case you cannot.
- Endorsers: Similar to guarantors, endorsers promise to pay the loan, but they also post some form of collateral.
- Accounts receivable: You promise to give the bank 65 to 80 percent of the receivables' value of the products that you sell as soon as they ship or are purchased from your store.
- Equipment: Any equipment you have can provide 60 to 65 percent of its value as collateral.
- Securities: If you are a publicly held company, you can offer stocks and bonds as collateral for repaying the loan.
- Real estate: Any property, either commercial or private, that is owned by the company can be counted on for up to 90 percent of its assessed value and used as collateral on the loan.
- Savings accounts or certificate of deposit: Any business or personal accounts can also be used as collateral for the loan.
- Chattel mortgage: If you use any equipment that you own as collateral, the lender makes a loan based on something less than the equipment's present value and holds a mortgage on it until the loan is repaid.
- Insurance policies: Any personal or business insurance policies can be considered collateral for up to 95 percent of the policy's cash value.
- Warehouse inventory: If you hold inventory then this can usually secure up to only 50 percent of the loan.
- Display merchandise: Any additional display merchandise or equipment that you have such as furniture, cars, or home electronics can be used to secure loans through what's known as "floor planning."
Unsecured loans rely solely on your credit rating. This means that you will not have to put anything up as collateral because your credit rating shows you are a reliable debtor. These types of loans are usually only for a few thousand dollars and are short-term with high interest rates.
Frequently Asked Questions
- Where should I look for loan options?
You can receive debt financing from the following sources:
- Banks or savings institutions.
- Commercial financing companies.
- Family, Friends, or Other Individuals willing to give you a personal loan.
- State and local resources that offer small business financing.
- Government sources that offer business financing.
- How do I know if I should use debt financing or equity financing?
If you do not already have very much debt and you have plenty of assets, it is recommended that you consider debt financing first. This way you do not lose any equity in your business. If you already have quite a lot of debt, going further into debt may not be a wise decision for your business. In this case, you should consider equity financing.
- How do you measure debt financing?
One way you can measure and compare debt financing is the debt-to-equity ratio. If a company's total debt is $2 million and the total stockholders' equity is $10 million, the debt equity ratio is one to five, or 20 percent. For every $1 of debt financing, there is $5 of equity. Usually, a low debt equity ratio is preferred. You can find both debt and equity on the balance sheet. Companies that have high debt-to-equity ratio will generally have a hard time getting more bank funding.
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