What is Debt Financing?
The term “debt financing” refers to when you take out loans to operate your business, in contrast to equity financing, where you get money from investors, who in return are entitled to a portion of the profits generated by your business. Debt financing can be classified into two types according to the kind of loan you’re looking for, whether it’s short-term or long-term.
Learn more about the process of financing your business with debt and how it operates, and the benefits and drawbacks of this method for running your company.
The Definition as well as examples of Debt Finance
Debt financing happens when a company borrows money to run its operations instead of obtaining funds through investors, known as capital financing.
Examples of debt financing are:
- Traditional bank loans
- Personal credit
- Credit from relatives or friends
- Government loans, which include Small Business Administration (SBA) loans
- Peer-to-peer loans
- Home equity loans
- Lines of credit
- Credit cards
- Equipment loans
- Real estate loans
What Debt Financing Work
It is possible to think of credit financing as falling into two types depending on the kind of loan you’re looking to obtain, such as short-term and long-term.
Long-Term Debt Financing
The term “long-term” refers to assets that your company is buying, like buildings, equipment, or land. It can also include machinery, as well as land. The lender typically requires that loans for long-term duration must be secured against assets that are properties to be bought.
When financing with long-term debt, the regular repayment of the loan and the expected useful life of the assets typically lasts three to seven years. The SBA guarantees loans. SBA may offer terms that extend up to 10-years. 1
Long-term debt is likely to be backed by fixed interest rates, which translate into monthly installments that are consistent and have a high degree of certainty.
Short-Term Debt Financing
Short-term financing typically applies to funds needed for daily operations of the company, for example, purchasing supplies, inventory or paying for the salaries of employees.
Short-term financing is known as operating loans or short-term credit because scheduled repayments occur in less than a year. The credit line credit could be an example of financing for short-term debt. Credit lines credit is often held by collateral (or collateral).
Short-term financing is typically utilized by businesses that are likely to face temporary cash flow problems when sales are insufficient to pay for current expenses. Businesses that are starting are more susceptible to issues with cash flow management.
The credit card is a common source of financing that is short-term for small-scale companies. According to a U.S. National Small Business Association study, 59% of small-scale business owners utilized credit cards to finance their business in the year 2017. 2
Benefits of Debt Financing
The primary benefit of using debt finance in comparison to equity finance is the fact that the loaner will not have an equity stake in your company. You own the business in its entirety, and the lender does not influence the business’s operations.
Interest on debt is tax-free as business expenses. In the event of long-term financing, the repayment period can be extended over some time, which can reduce the monthly cost. If the loan does not have a variable interest rate, the interest expense is an established amount to be used for planning budgets as well as plan-of-action for planning purposes. Other benefits include:
- Creates the business credit
- It provides leverage to the equity of owners.
- Provides stability when planning budgets and plans for the future.
- Long-term loans can reduce dependence on less expensive short-term alternatives.
Advantages of Debt Financing
For extended loans, banks usually require that the company’s assets be pledged as collateral for the loan. If (as is typical for small-sized businesses) the company doesn’t have enough collateral to secure the loan, then lenders may require personal guarantees from the business’s owners.
As a business owner, you are the sole person responsible for repaying the loan, regardless of whether your company has been incorporated.
If your company cannot pay the loan, the personal assets you used as collateral can be taken from the lender, your house, cars, a vehicle, investment accounts, etc.
When financing with debt, the set repayment time frame and the high cost of repayment for loans can hinder businesses from growing.
Equity financing is when money is invested into the company to acquire equity. There is no set date for a refund, and investors typically look for a long-term return on the investment.
Suppose your company requires equity or debt-financed financing. In that case, it is essential to have an effective plan for business in the works before any investor or lender is willing to provide you with funding.
This is a must, as it includes your company’s financials like an income statement and cash flow projections, and the balance sheet.
pay back the loan