Debt Financing
Most small businesses apply for debt finance at some point during the business lifecycle. It could be to get your business idea off the ground, to purchase equipment and assets for core business operations or to support your cashflow. Understanding the different debt financing options and how they work is really important – some options may be more suitable for certain types of businesses or what you intend to do with the funds.
In this guide, we’ll cover the fundamentals of debt financing and how it works to help you make informed decisions for your business.
What is debt financing?
Debt financing, also known as financial leverage, is when a business borrows money from an external lender and repays it over time or at a later date while accumulating interest, e.g. business loans. It’s one of the two most common business financing methods – the other method is equity financing which involves selling shares and does not need to be repaid (we’ll touch on equity financing in a bit more detail later on).
What are the different types of debt financing?
There are a number of different debt financing options. We’ve summarised the most common types below:
- Business loan: An amount of money that is borrowed from a financial institution, private lender, family member or friend and repaid with interest over time.
- Line of credit: A flexible loan from a bank or credit union that you can use as and when you need. You can repay it straight away or after a period of time.
- Business overdraft: An amount of money you withdraw from your business bank account that is more than what is available in your credit balance. Business overdrafts have certain terms specified by your bank, e.g. to pay the overdraft amount back within a certain time frame.
- Bond: An amount borrowed from an investor or lender that is repaid over an agreed amount of time with interest. Unlike loans that are fixed with the original lender, bonds are highly tradeable and can be bought and sold in the bond market.
- Invoice financing: An amount borrowed against the outstanding amounts due from your customers. Invoice financing can help you maintain and improve cashflow without having to wait for customers to pay their balance in full.
- Asset financing: When you use your balance sheet assets (e.g. inventory and investments) as security to take out a loan against what you currently own.
- Equipment financing: Funds borrowed from a lender to purchase and own machinery, equipment or other assets outright. You repay the loan with interest over an agreed repayment period.
How does debt financing work?
Every debt financing option has different terms, interest rates and repayment periods. That said, there are generally two main types of debt financing:
- Short-term debt financing
- Long-term debt financing
Short-term debt financing is mostly used for day-to-day/business as usual type of expenses such as office stationery, inventory and supplies, wages, etc. As this type of funding tends to be smaller, you can usually repay short-term loans in less than a year. On the other hand, long-term debt financing is usually required for purchasing large assets such as land, machinery, buildings, etc. Long-term debt is repaid over a longer period of up to 10 years.
There are a number of different sources for both short and long-term debt finance including:
- Financial institutions - i.e. banks, building societies, credit unions
- Registered finance companies
- Factor companies
- Suppliers (for trade credit)
- Retailers (for store credit)
What are some examples of debt financing?
Below are some examples of when small businesses may apply for debt financing:
Example 1: A local salon wants to make some renovations to open up space to seat more clients. They borrow $10,000 from a bank with an interest rate of 4.2% and a repayment period of five years.
Example 2: A small courier company wants to purchase additional vans to scale its business operations. They decide to take out a loan and use their existing vehicle fleet as security for the loan. This is known as asset financing.
What are the advantages and disadvantages of debt financing?
While debt finance is one of the most common financing options for small businesses, it’s good to understand the pros and cons to determine if it’s right for your business:
| Pros: |
Cons: |
| Ownership: Unlike equity financing, debt financing allows you to keep full ownership and control of your business. |
Risk: You are personally liable for repaying debt and your business and personal assets may be at risk of being seized if you can’t pay back the loan. |
| Accessibility: Debt finance tends to be more accessible and flexible than other financing options. |
Financially strenuous: Meeting repayment conditions can be difficult to juggle while also trying to grow your business or if you don’t have a steady cashflow. |
| Tax-deductible: You can claim debt interest costs as a business expense on your tax return. |
High interest rates: Interest rates can be fixed or variable and both can be good and bad depending on loan market conditions. |
| Build credit rating: It gives you an opportunity to build and improve your business credit rating. |
Risk to credit rating: Late or missed payments can have a negative impact on your credit rating. |
The good thing with debt financing is the wide range of options available, but there are other options to consider if you don’t think it’s a secure and reliable option for your business.
How much does debt financing cost?
The cost of debt financing depends on the interest and fees added to the base amount you borrow. Every lender will have their own terms and interest rates, so make sure you compare quotes and clearly understand the rates and terms before formally agreeing to anything. Remember, the interest on debt is tax-deductible so this will reduce the overall cost of the debt.
Regardless of how you fund your business, it’s vital to have a solid business plan that explains and evidences your financial model to persuade lenders. Any lender or investor wants to see that your business financials are secure before they hand over any cash.
What are the alternatives to debt financing?
There are a number of different financing options for small businesses including:
- Equity financing
- Mezzanine financing
Equity financing involves selling shares/ownership of your business to an investor in exchange for cash. Equity finance can be raised through private investors or a public stock exchange. The downside of equity finance is that you will not have total ownership of the business or profits, but it does have the advantage of not having to be repaid so you can better invest profits and focus on growth.
Mezzanine financing is a hybrid of debt and equity financing and is the highest risk type of debt for equity loss. That said, it can offer some of the highest returns. Mezzanine lenders usually buy out some of the capital that would typically be invested by an equity investor. They offer you a subordinated loan in exchange for potential equity interests with flexible repayment options.
Who can help me with debt financing?
Navigating the different debt financing options can be complex and time-consuming. With so many options available, it can be tricky determining the best options for your business and negotiating debt terms and interest rates with lenders. Working with a business loan broker can save you a considerable amount of time as they can help you find suitable debt finance solutions and negotiate more favourable terms and rates on your behalf. Learn more about business loan brokers and the services they offer.
