Debt financing is considered one of the two main ways small business owners can finance the operation and growth of their business. This type of financing allows one to borrow a certain capital for business, as opposed to equity financing, where you need to raise money from investors who are then entitled to own a profit share in return.
Many small business owners usually resort to this external financing option when internal financing sources, like business savings or personal funds the owner can use are unavailable.
What Is Debt Financing?
When it comes to small businesses, debt financing usually means borrowing money from outside the company to fund business operations. As a business owner, you will be responsible for paying the debt according to its terms, including the interest charge. Generally, the repayment schedule for the principal and interest is set when the financing occurs.
When you think of debt financing, you automatically think of borrowing money from a bank through a bank loan. However, it is vital to know that there are multiple types of debt financing, which usually depend on your business needs and ability to pay back the debt. This includes loans from online lenders like CreditNinja cash loans, lines of credit, business term loans, cash flow loans, and many more.
Debt financing can either be short-term or long-term. It is considered short-term when the debt maturity lasts less than a year. Meanwhile, it is long-term when the debt maturity lasts for more than a year.
Debt financing can also either be considered secured or unsecured. When we say secured, this means that it has collateral. On the other hand, it becomes unsecured when the lender doesn’t require you to pledge any collateral for the loan to get approved.
Pros of Debt Financing
The following are the benefits of choosing debt financing to fund your business needs:
Unlike the other forms of financing, such as equity financing, debt financing helps you maintain full control of your business. However, when it comes to this option, a lender will only help you fund your business by letting you borrow money but will have no control or say in your business’s daily operations.
The interest payments your business pay are considered tax deductible when it comes to debt financing. It is essential to know that this deduction is available to various business owners. This includes partnerships, corporations, and sole proprietors.
Multiple costs of financing a loan are also considered tax-deductible. An example of this is origination fees. Furthermore, these tax benefits could also help lower your interest rate.
Debt financing can be easier to access than other financing options like small business grants and equity financing. This is because you can easily apply for debt financing from different lenders. This includes banks, credit unions, and online lenders.
Variety of Options
You can choose many types of debt when it comes to debt financing. This includes lines of credit, term loans, and many more; you will likely find the best type of debt to meet your business needs.
Builds Business Credit
If you maintain good payment history, debt financing can build and improve your business credit score. This is beneficial, especially when you continue to grow your business financial profile. In addition, a good credit score will increase your chances of qualifying for other types of debt financing you may want to get in the future.
Cons of Debt Financing
The following are the cons of debt financing for your business needs:
If you choose secured debt financing, the disadvantage is quite apparent. When it comes to secured financing, your business assets are at risk if you can’t pay back the debt. In addition, if you have insufficient collateral, the lender will more likely require you to sign a personal guarantee.
If you agree to the personal guarantee, you will personally be responsible for the loan instead of your business. Thus, if your business experiences problems and can’t repay the loan, the lender can seize your personal savings, car, house, and more.
Cash Flow Impact
Depending on what type of loan you get, you might also find it challenging to grow your business while repaying your loan monthly. In addition, if you choose a loan with a variable interest rate, the repaying amount you give per month could fluctuate. Hence, this could have a great impact on your cash flow.
As mentioned earlier, debt financing is easy to access. However, it is challenging when you are a startup or have bad credit.
Most of the time, lenders will assess your business credit to know your ability to repay the loan. Thus, if you are a startup, you won’t have any credit history to show. Plus, if you have bad credit, you will be considered by the lender as a loan risk.
To Sum It Up
Debt financing is a tool you can use to fund your business needs. The process is you borrow money from a lender outside your company and pay back the principal on the set schedule with interest. Furthermore, before you pursue debt financing, it is best to understand the pros and cons to help you choose the right decision.