Debt financing is a method of financing your enterprise through borrowed cash. When the lender provides the loan, the debtor should pay the money within particular conditions in a stipulated period.
Usually, the repayment involves the borrowed amount plus the accrued interest.
You can get both secured and unsecured loans. Security is the collateral you give the creditor that you are willing and able to forfeit should you fail to pay. Collateral may involve fixed assets such as a plant, real estate, unpaid invoices, inventory, or the business itself.
You can get a long term or short term debt financing, depending on your financial needs and goals. The long term loan is for acquiring fixed assets and maintaining them while the short term debt provides working capital for your business.
Factors to Consider When Choosing Debt Financing
There are several options for debt financing, and the best one depends on the type of business that you have. Below we have compiled a list of the factors that we feel are non-negotiable in choosing a loaning option.
Use of Money
There are specific loans for carrying out particular activities. For example, capital finance for acquiring your business capital. An equipment loan is needful when you want to purchase an asset.
Amount of Money you need
Before taking a loan, you should budget and calculate the amount you need. You should not get more money than you need as you will have to pay the principal with interest.
With your budget and the amount you need, you should know the repayment plan and determine whether your business can sustainably help in the paying back.
Type of Business
The nature of the business determines the best option of debt financing definition. For example, if the company can generate daily, weekly or monthly income, you get debt financing with a scheduled payment plan. However, if you have a seasonal business that is unpredictable, a merchant or a friend may be the best loan source.
Ability to Qualify
We should be well versed with the different types of debt financing and the ones you qualify. We need to gather relevant information to know what is required, the kind of business, and the repayment plan. Knowing beforehand whether we are eligible helps us readjust our business goals as we apply for the loan.
Affordability of the Loan
We should determine how affordable it is and whether your business can sustainably service the loan. One of the things you look at is the interest rate charged and the terms of repayment. Can we easily align the loan to our business goals? If yes, we may go ahead and apply for the loan.
How Debt Financing Helps your Business
When financing a business, we choose either equity financing or debt financing.
Equity financing involves getting capital for your business from an investor without any repayment obligation. However, we give up a share of the company to the investor. No major decision will be made without involving the lender, and they will also receive a percentage of the profits.
Debt financing, on the other hand, is advantageous since the relationship with the lender ends once the debt is paid. They will not influence the business decisions; neither will they get a share of the business.
Why do we choose to use Debt Financing vs equity financing? Below, we provide a few ways that loans help your firm.
• If the company is growing at a high rate, debt financing is a cheap source of growth capital.
• Debt financing is simple and straightforward compared to asset financing. You may not need the approval of shareholders or a lengthy legal process.
• The ownership of the company remains. No dilution of owner’s equity in the company. In the long run, this increases profit margins and returns. In equity financing, the lender has a percentage in the company. If we want to maintain that equity unless you buy back from the lender, which will be more expensive than the initial amount.
• A loan helps the firm build its equity progressively as the loan repayment continues.
• The interest charged on the debt is tax-deductible. Also, other charges such as origination costs, and loan services costs are tax-deductible whether you are dealing with a sole proprietor, state-owned corporations or companies. Ultimately, the interest rate you pay is minimal.
Even with these great uses, debt financing has a few downsides.
• If we are unable to repay your loan, we may lose our assets like a house, business, savings, or even inventory. Such can take such a long while to recover. Also, we are fully responsible for the loan, and no one else will assist us. And the creditor may require you to sign a guarantee form. All this is difficult, knowing that the business environment may be unpredictable.
• Loan repayment can slow down your business growth. Being required to set aside a certain amount of your profit can be demanding for your new business.
• If operating on a variable interest, the amount may fluctuate from month to month, making your capital planning a bit challenging.
• Getting high debt amounts may negatively affect your credit rating. Such a rating may influence your ability to get future loans.
Even with the above disadvantages, with proper planning, debt financing may be the best alternative of funding our businesses.
Types of Debt Financing
Term loans are the most obvious types of business loans. It involves borrowing a specific amount, called the principal. You will pay back the principal plus a certain amount of interest. When applying, we usually specify the reason for the loan, and the repayment period is agreed upon beforehand. The installments are typically predetermined and paid monthly.
Business Line of Credit
It is a flexible form of business financing that gives you money to meet various business needs. This funding allows you to draw a line like with personal credit cards. You can use this money for virtually all business operations, such as paying off debts, purchasing inventory, or address seasonal cash flows.
Merchant Cash Advance
The merchant gives us a lumpsum amount to boost our business and get a percentage of future sales. Each day you make a sale, you pay the merchant plus some interest. Although they are easy to qualify, they end up being too expensive and eats up into the business’s working capital.
In this form of funding, companies purchase your accounts receivables. This financing occurs when clients delay in payments and thus affect your working capital. In the future, when you are paid, the priority will go to the lender, may 80% of the paid invoices as you receive the rest.
It is a kind of loan that you are given a certain amount of money to purchase given equipment for your business. For example, a machine, computers, vehicles, among others. The asset acts as the security for the loan, and should you default, you only lose your equipment.
Small Business Administration
SBA is a federal agency committed to helping small businesses gain business funding, utilize contracting opportunities, and grow progressively. It does not provide loans but supports small businesses to access various types of financing through loan programs and microloan programs.
Loan Application Process
The process of debt financing ranges from simple to complex, depending on the loan product and the lender. This whole process seeks to ascertain that we can repay the loan successfully.
As such, we will need to have the right documents to prove business ownership. Some of the documents you need are:
• Proof of business ownership – Unless you are the owner of the business, you do not qualify for the loan.
• Business License – this shows that the firm complies with all local, state, and federal licensing requirements. Some businesses must provide industry-specific licenses.
• Business plan – most lenders require a detailed business plan, showing how the cash will be utilized. It also shows we are serious about our venture and we have thought through the process.
• Franchise Agreement – Businesses that are part of a franchise will require an agreement from the franchisor.
Documents to Prove Financial Health
The financial health of your business is the primary determinant of your repayment ability. These include:
• Balance Sheet – We cannot qualify for business loans if our balance sheets are not updated and accurate. The lender may also want us to provide the balance sheet for two previous years.
• Business Tax Returns – Tax returns provide us with long term revenue history. Have tax returns of about 2 to 3 years at hand when applying for a loan.
• Personal Tax return – When applying to finance a new business, most loan brokers ask for personal tax returns.
• Profit and Loss Statements – It shows the income and expenditure of a company.
• Bank Statements – These show your cash flow. We should acquire an updated statement.
• Sales Forecast – With an accurate sales forecast, we get a higher standing in the loan application.
Debt financing is an incredible way of finding money to boost our business growth. It requires proper planning, and when done accordingly, it can promote our businesses without losing our share through equity.
Why do companies use debt financing?
There are many reasons why a finance company would want to use debt financing. First of all, it is vital to decide where the capital will come from when a business starts, by its implications for financial projections. In the beginning, it will come from equity, but in the business world, there are several decisions that are unavoidable, such as a business loan. Regardless of the sector in which the company operates or the main activity it engages in, a financing option is necessary. Debt financing can be a small business loan or a large business loan, which is used to improve or protect cash flow, as well as to finance growth or expansion through debt capital. As long as the company meets the requirements, as a clear business plan, that defines the objectives of the business and how it plans to achieve them. If a company applies for external financing at any time, these requirements provide essential information about the company to the investors or the lenders.
Is debt riskier than equity?
Debt as financing serves to access money through a bank or a person’s loan with its respective interest, where there will be a fixed maturity for interest payments, regardless of the behavior of the business. In equity, individual investors or a financial institution offers the money, and they expect to have a share of the future profits, but also share the risk of bankruptcy. If the owner of a company turns to many investors, or these are capital funds, he will have to invest in the corresponding legal procedures. Since the owner has an obligation to make the decisions that are in the best interest of all investors, and if the amount invested by the investors is immense, their participation causes the owner to have less control over the company. The investor is more likely to take risks in these areas, as there is a regular payment schedule for the debt, which in many cases can be accelerated by default, and in the event of a liquidation or bankruptcy is paid before the principal.
What are advantages of debt financing?
There are many advantages to opting for the financial debt. Lenders will not have any influence on business decisions. The owner does not have to take care of anyone, so control of the business will remain in his hands, as will his profits that he does not have to share with the lenders. Debt financing allows for the payment of new equipment and new assets to grow a business before it earns the necessary funds. This can be a great way to pursue an aggressive growth strategy, especially if there is access to low-interest rates. There is the advantage of paying off the debt in portions over a period of time. Another point in favor of debt is its fixed cost, unlike private capital, which has a variable cost that tends to exceed that of debt. Ideal formula to start a business would be with its own capital and, when the needs of growth require it, access to debt without losing control of the business.
How does debt financing affect the balance sheet?
Financing is mainly a topic of commerce. The company is always trying to spread the cash flows created by its assets across various financial instruments that attract investors with varying tastes, wealth, and tax rates. When a company collects resources through debt financing, the cash flow statement’s funding includes a favorable component and a rise in the balance sheet liabilities. Debt financing involves creditors and interest, which should be paying in full to lending institutions or debt holders. Although debt doesn’t dilute property, debt interest payments reduce net income and cash flow.
What are the risks of debt financing?
The level of debt will be determined by what the company can pay and what satisfies the owners. When contracting a debt, it is necessary to consider that sales behavior is a variable that implies risks. A risk means the possibility of the occurrence of an event, as well as the consequences thereof. Now, financial risk is an uncertainty that an investor has when contributing resources to investment and has no assurance about the amount he/she will get at the end of that operation. It is crucial to assess the risk that the debt financing may have, as it requires some evaluation that a small business owner needs to do for a venture lender if the owner wants to apply for venture debt financing as well. These risks are related to market behavior, monetary stability, and stock valuation in the market or lack of liquidity. When it is a market risk, it can alter interests and significantly affect the company. When it is credit risk, the company loses credibility with the financial system. When it is liquidity risk, there may be an absence of cash for its operation. Finally, the operations that imply a more significant economic profit are also the riskiest. Still, it is always advisable to study the relationship between risk and profit that financial operations offer.