When you are growing a business, there are bound to be times when you need to invest money into your efforts. This could be to develop a new product, scale your marketing or take on more staff. If you don’t have savings or a way to fund it yourself, you might feel stuck, as growing a business isn’t easy without capital. Luckily, debt financing is an option.
What is Debt Financing?
There are a variety of ways to come up with money to start, grow or develop a business. One of these is debt financing, also known as debt lending. This is a method used by businesses to borrow money from lenders or investors, to raise capital, which can then be used to finance new ventures. Debt financing works by a business – or an individual, as debt financing can also be used to raise personal capital – taking on debt, with the intention to repay the debt over a specified period of time. The debt is usually in the form of loans or bonds, and the repayment usually includes added interest.
Though debt financing can be utilised by all businesses, it’s especially common for new and small businesses, who use debt financing to boost growth efforts. It’s often the preferred route when other financing options are unavailable, such as a business loan or personal savings.
How Does Debt Financing Work?
A lot of people make the mistake of assuming that debt financing is complex, but it doesn’t have to be. To put it simply, when a business needs money, they can choose to sell equity and take on debt. A business’ financing choice will likely depend on factors such as the amount needed, the borrowing period and interest rates. Many businesses choose to finance their business – this could be related to growth, innovation or product development – by selling fixed income products, such as bonds, to willing investors.
When a business sells bonds, the investors who purchase the bonds become lenders. Unlike equity financing where the lenders receive stock, debt financing must be paid back. This loan must be paid back in the future, and the exact terms are agreed before the debt financing is finalised. If the business goes bankrupt or closes in the meantime, lenders have a higher claim on any liquidated assets than the shareholders do.
What are the Pros and Cons?
As is the case with any type of financing, there are pros and cons to debt financing, which is why it’s an option that a lot of businesses consider. Before deciding whether to go ahead with debt financing, it’s important to consider the advantages and disadvantages, and weigh up what’s best for your business and long term goals. Here are some of the key benefits:
Access to Capital – With debt financing, businesses have access to much needed funds quickly. This allows borrowers to meet urgent financial needs or take advantage of business opportunities without the risk of missing out, simply because the funds aren’t available.
Tax Benefits – There are tax benefits to debt financing, which is a huge appeal for businesses. Interest payments on debt are often deductible on a tax return, reducing the business’ taxable income and potentially resulting in paying a smaller amount of tax.
No Dilution of Business Ownership – With debt financing, businesses maintain ownership and control of their operations. Investors and lenders don’t acquire any ownership stakes in the business, so business ownership isn’t diluted or spread between more people.
As well as the above benefits, there are also a handful of downsides to debt financing to consider, including:
Cost of Interest Payments – Regular interest payments increase the overall cost of borrowing, and this could affect a business’ profitability. This can be a problem if the business faces cash flow problems.
Risk of Missed Repayments – Failure to make timely repayments can lead to a default, which can impact a business’ credit score. It could also result in penalties and legal action if the repayments aren’t caught up on.
Covenants and Lack of Flexibility – Lenders often impose covenants and restrictions on borrowers, which could limit financial flexibility. Covenants and restrictions could also hinder the business’ ability to make business decisions, as debt financing will need to be taken into account.
Is Debt Financing Right for Me?
There is no ‘yes’ or ‘no’ answer for this question, as every business is different. There are a variety of factors to take into account, such as your business’ financial situation, your long term goals and how willing you are to take a risk. Though debt financing is an effective way to raise capital for a lot of businesses, that’s not always the case. Here are some things to take into consideration when deciding if debt financing is right for you.
Your Financial Situation – Think about whether you have a reliable source of income and a strong cash flow, and if you can keep up with regular repayments. Consider if you can handle the burden of additional debt.
Reason for Borrowing – Determine if the borrowed money is likely to generate enough returns to cover the cost of debt, and if the funds will have a positive impact on your finances in the long term.
Risk Tolerance – Think about how comfortable you are with taking on debt and the associated financial obligations that come with doing so. Determine if you can handle the consequences of a possible default, such as penalties and legal action.
Alternative Financing – There are a range of ways to finance a business, so consider all of your options before settling on debt financing. Consider if equity financing, investors, venture capital or personal savings are a better option.