Securing the funds to start organically as a new startup business can often be tricky. Most investors will need to see evidence of strong financial performance before they choose to help business owners with additional funds and assistance.
As a result, most new businesses will need to turn to some form of external financing or borrow money to operate. This additional funding is often used to establish the initial infrastructure regarding business assets and personnel.
This is known as debt financing.
The term ‘debt’ is often misunderstood. Most successful companies will have had to take on some form of debt as part of their early business plans. As long as the debt is managed carefully, with monthly payments settled as promised, debt can be a good thing for a business.
Let’s get to the following commonly asked questions:
Debt financing is a form of financial leverage that involves a business borrowing money from financial institutions, such as banks, to improve operations for business growth. This form of business finance is paid back according to a pre-arranged payment plan and is subject to interest.
It is considered a form of ‘good’ debt, as the business will likely be in a stronger operational position once the debt has been paid than it was before taking on the debt.
There are several funding options for a business to choose from when it comes to financing debt.
The most common of these are traditional bank loans. This is where a business will take a cash advance from a bank and pay it back over a set period whilst accruing interest. Bank loans are a reasonably safe option as interest rates are often low, and there is flexibility over the period for the loan to be paid back.
A company can also organise a line of business credit to assist with growth and stability. A bank will provide a fixed amount of funds a business can draw upon as and when required. A business is only required to pay interest on funds withdrawn; when these funds have been paid back, the line of credit resets.
Similarly, a company can set up a business credit card. They work in the same way and are often considered a type of revolving loan, but the main advantage of a credit card over credit lines is the additional perks and rewards that often come with it.
Both methods have the additional benefit of improving a business’s credit rating, which can help secure good deals with other lenders.
If you are considering taking out a credit card for your business, check our credit card comparison tool to find the best deal.
There is also a financing type known as a merchant cash advance, which involves receiving a lump cash sum upfront. However, instead of fixed monthly instalments, the business pays the loan back through a portion of its sales. This is a high-risk financing debt due to its high annual interest rates and fees.
Loans from family members are also an example of debt finance.
Many people will choose debt financing to retain control and ownership over a business. Banks will provide the necessary capital and expect the debt to be paid back, but they will not get involved in the day-to-day running of a business. If an external investor chooses to get involved, this may not be the case.
Fixed repayments can also make budgeting and planning for the future easier. There is also the added benefit that low-interest business loans can help a business quickly build a strong credit history which might be essential if larger loans are needed further down the line.
Finally, interest payments on a bank loan are often subject to tax deductibility.
Note: To benefit from these tax deductions, the business must prove using the money for business purposes. The money must also come from an actual lender rather than friends and family.
While this form of raising capital has several notable advantages, debt financing has a few cons.
The main one is that, ultimately, you are relying on your business to succeed in making the repayments. Even with all the risk management and due diligence in the world, this is not guaranteed. A failing business could quickly be caught up in bad debt without steady cash flows and revenue.
Missed repayments due to inconsistent or unpredictable income will negatively impact existing credit scores.
New businesses may also struggle to secure the best rates for their loans. This is because they may not have been around long enough to build a strong credit history.
When it comes to debt financing vs equity financing, the main difference is what happens to the business's ownership structure.
By financing your business through debt financing, you will maintain control of your entire business and make repayments on loans provided by a financial institution. However, businesses that choose equity financing will sell partial ownership and stakes in the business to external investors in exchange for capital.
Short-term debt financing is generally used to cover day-to-day costs during the initial building of the business. Bank loans and lines of credit are typically extended to twelve months.
In contrast, long-term debt financing is used for larger-scale projects once the business is financially sound. Bank loans are usually extended over longer periods and are typically used to pay for additional buildings, machinery, or business acquisitions.
Debt has a bad rep, but if you use it wisely and strategically, it can give you access to opportunities you wouldn't have otherwise.
If you want to finance your business with debt, you should first consider why you need the money, how much you need, and how much debt you can afford. Lastly, it’s a good idea to talk to a professional financial advisor to get the right advice if you have any concerns.
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Disclaimer: The author is not a financial advisor, and the information provided is general and was prepared for information purposes only. This article should not be considered to constitute financial advice. Accordingly, reliance should not be placed on this article as the basis for investing, financial or other decisions. This information does not consider your investment objectives, particular needs, or financial situation.