Debt financing - What is debt financing?
Debt financing refers to when a company borrows money to be paid back at a later date. The most common forms of debt financing are bank loans and funding from investors.
Searching for financing opportunities for your new business? Check out our guide on how to get financial backing from a bank or investor.
Debt financing is one of the two main forms of business financing. The other form is equity financing which includes selling stocks to raise funds. Debt financing must be repaid whereas equity financing does not.
How does debt financing work?
Debt financing is when a company takes out a loan to be repaid at a later date with interest. There are a few different methods of receiving the funds:
- A loan from a bank or credit union
- Selling bonds to lenders or the public
- Loans from friends or family
- A cash advance on a credit card
- Peer-to-peer lending
Each method of borrowing may have different repay periods and interest rates. It is important to explore several options and choose the one that would best suit your business.
Short-term vs. long-term debt financing
Short-term debt financing is usually used for the day-to-day operations of the business. This may include salaries, office supplies, inventory, etc. This form of funding is generally a smaller amount than long-term debt financing and has a repayment schedule of less than one year.
Long-term debt financing is generally used for large assets such as purchasing large equipment, buildings, machinery or land. The repayment terms are for a longer period, usually between three to seven years.
Advantages of debt financing
Compared to equity financing, the main advantage of debt financing is that the lender does not buy ownership of the company. This means that you will remain the owner of the business, and they will have no control over the day-to-day operations.
Another benefit of debt financing is that the interest is tax-deductible as an expense. The repayment period is also longer making it easier to budget for the loan and make monthly payments.
Having a long-term debt financing loan may also build up your credit score as you will be making monthly payments over a long period of time. This will help your business gain future funding if needed.
Disadvantages of debt financing
Although debt financing may be the best option for your business, there are a few downsides that you should be aware of.
If you receive a long-term bank loan, the bank may ask for collateral in case of default. If your business is new and does not have enough assets, then the lender may ask for personal guarantees from the owners. Therefore, if your business defaults on the loan, it will be up to the business owners to repay the debt.
Certain types of debt financing may have a high-interest rate. If your business utilises one of these loans, you must ensure that your business will be able to repay the amount including the interest.
On that note, most lenders will require a detailed business plan prior to offering any funding. Make sure that it is detailed and achievable so you won’t run into any issues.
