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Debt Financing – Loans For Small Businesses – Pros & Cons

Debt Financing Options

Considering financing options is inevitable in any business venture, especially for startups and small business owners. At some point or another, small business owners need extra capital to buy a vital piece of equipment, purchase inventory to boost sales, or to hire new help because business is booming. No matter the situation, many business owners eventually consider the variety of financing options to help keep their business afloat, or to help expand their successful business venture. Many small business owners start with considering the two most common forms of funding: debt financing and equity financing. There are plenty of advantages and disadvantages associated with both debt and equity financing, but to better understand debt financing, here are the major differences between the two funding choices.

  • Debt Financing: Debt financing is essentially the technical term for borrowing money from an outside source such as a bank or other financial institution. With debt financing, business owners promise to return the initial principal loan amount with an agreed upon level of interest and predetermined maturity date; this type of financing is often secured by some (or all) assets of the company.
  • Equity Financing: Equity financing is a popular way for most startup companies to obtain funding, but this does not mean equity financing is limited to only startup businesses. Through equity financing, cash is paid into a business by investors (for startups, this is commonly venture capitalists). In exchange for cash, investors receive a share of the business, often a percentage of it proportional to the investment paid to the business. Many business owners enjoy the theory of equity financing, particularly because it allows capital to be allocated to other important areas of the business instead of having to repay debt financing. Unfortunately, equity financing comes with many drawbacks, with less control of day to day business operations being a main concern for business owners.

Understanding Debt Financing

With debt financing, the lender is paid back each month, regardless of how well the business is doing that month, which is why it is so important to fully understand debt financing rates and terms before making any final loan decisions. Most small businesses prefer to go through the Small Business Administration because they set guidelines for loans and back a portion of the lenders losses, allowing more small businesses to obtain debt financing easier.

Obtaining debt financing can prove to be difficult and tedious, but for many companies, it can be much more beneficial to a business than equity financing or other alternative funding options. Surprisingly, debt financing can provide funding at lower rates, the interest on the loan is often tax deductible, and provide more useful opportunities than other forms of funding.

Debt to Equity Ratio

Understanding the debt to equity ratio of a business before finding debt financing is essential. A debt to equity ratio is a metric that banks and analysts use to measure and compare the amount of a company’s capital that is being financed, otherwise known as a business’s financial leverage. This is done by dividing a company’s total liabilities by the company’s stockholder’s equity (Debt – Equity Ratio = Total Liabilities / Shareholders’ Equity). If a business owner has a high debt to equity ratio, this generally means that a business owner has used financing and loan methods heavily during the business’s growth stages; this is otherwise referred to as aggressive leveraging. With aggressive leveraging comes an associated high level of risk which often deters banks from lending to a business owner. This is often when a company decides to consider equity financing options. If a business owner has a low debt to equity ratio however, lenders see this as a good business with limited risk, allowing a business owner to have a better chance at obtaining debt financing.

Advantages of Debt Financing

There are a variety of advantages for business owners to obtain debt financing, but the most common benefits include:

  • Retain Ownership: With equity financing, business owners exchange a piece of their business for capital which often comes with investors wanting to be a part of day to day operations – this is one of the main reasons business owners opt for debt financing. Through debt financing, the business owner may have to repay the loan back each month in small installments, but the business owner can still run the business however they want without outside interference.
  • Acquisition Proceeds: With debt financing, there is no specific exit agreement put in place to pay out a certain percentage to investors (like there is with venture capitalist funding) if the company is acquired. Instead, proceeds go to the business instead of being split up amongst lenders.
  • Tax Deductions: For most businesses, the principal and interest payments on a company loan can be classified as a business expense, allowing these payments to be deducted from a business’s income taxes. This is often a considered a major advantage for small business owners.
  • Easier Planning: For business owners out there who like to have all of their ducks in a row every month, debt financing is another major advantage. Through debt financing, business owners have the ability to know exactly how much will be repaid each month, allowing many business owners to find ease in budgeting and dealing with other financial business plans.

Disadvantages of Debt Financing

  • Repayment and Cash Flow Issues: Unfortunately, many business owners will experience difficult times, resulting in major cash flow issues. Cash flow issues are then directly correlated to the inability to make a month payment on the business loan. Repayment may also be an issue for a business owner who has a track record of paying bills late – this does not mean this type of business owner cannot be successful, but that debt financing may not be the best option for that business.
  • Credit Rating: What a business owner borrows will affect their credit rating – positively or negatively. When borrowing larger loan amounts, the impact on a credit score for lack of payment can be detrimental. This will also diminish changes of borrowing from lenders in the future.
  • Collateral: Many traditional debt financing lenders required that the business owner provides some type of business collateral, resulting in business assets being at risk. An alternative to putting up collateral for debt financing is by the business owner personally guaranteeing the loan, but this puts personal assets at risk if the loan is defaulted.

Types of Debt Financing Options

Types Rates Terms Funding
Bank 6-10% 3-7 years 14-30 days
SBA 6-10% 3-7 years 10-30 days
Line of Credit 5-15% 1 – 3 years 7-30 days
Alternative 6-25% 1-5 years 5-7 days
 Cash Advance 1.16-1.55 3-24 months 1-3 days

Bank Debt Financing

Debt financing through a bank offers the lowest rate and longest terms of all small business financing options. Uses can include purchase or refinancing of real estate, commercial mortgages, working capital among other uses.

SBA Debt Financing

There are a lot of similarities between bank debt financing and SBA debt financing, mainly because both loan options are provided by conventional lenders. The only real difference is that SBA lending involves the government agreeing to back a portion of the loan to protect the lender in case the small business defaults.

Alternative Debt Financing

Alternative debt financing is the mid path between bank and SBA debt financing, and some of the high-interest, short term financing offered to small companies. Alternative debt lenders have streamlined the approval and funding process to allow for fast funding. But with quick funding comes higher rates than bank loans.

Debt Financing Cash Advances

Cash advances are a way for companies to obtain fast short term financing, without having to obtain a traditional debt financing facility. Cash advances are the sale of the companies short term future receivables in exchange for cash.

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