One of the two main types of funding for businesses is debt financing. Equity finance is another common form of funding. Equity finance is another popular method to secure funds for growing businesses. It can be used as an alternative or traditional source of funding.
An enterprise can borrow money from a third party to secure capital or funds. Then, the company pays back the borrowed amount with interest and charges. This financing option does not require you to give up any equity in your company in return for funding.
How Debt Financing Works
There are three types of loan programs to be aware of:
- These small business loans include fixed payback terms and monthly installments. After receiving a lump-sum payment upfront from the finance company, the debt will be repaid monthly until it is fully paid off. These are just a few examples of common types: Equipment finance, SBA loans and terms loans.
- Revolving loans
These loans let you borrow against a revolving credit line that you can use, repay and repeat as often as you like. Credit cards and business credit are two common forms of revolving loan.
- Cash flow loans
Once you have been approved for a cash flow loans, the lender will make a lump sum payment. Instead of setting a repayment period, the lender will pay you the loan in a lump sum as you earn the money. When they need additional capital, many businesses turn to invoice financing and merchant cash advances.
Repayment Terms for Debt Financing
- Long-term debt financing
Long-term debt financing is most commonly used to finance assets such as equipment, land, buildings or machinery. These debts and assets that you have purchased will be repaid over five years.
- Intermediate debt finance
Infrastructural debt financing loans can be used to finance medium-sized expenses and help the company grow. They are repayable in three years.
- Short-term debt financing
Short-term funding is often required for day-to-day expenses. You can use a short-term loan to buy inventory, hire employees, or purchase supplies. These loans are short-term because they have a shorter repayment term than one year. One of the most preferred short-term debt financing options is credit cards.
Different types of debt financing
- Conventional bank loans
This loan can be used to help your company grow over the long-term or medium term.
Both commercial lenders and credit unions offer bank loans to borrowers. They are different from other loans that you can get online or through alternative lenders because they have strict eligibility requirements. The main problem with traditional bank loans is their low interest rates.
- SBA loans
The Small Business Administration approves loans that are best suited to small businesses. SBA loans are often used by businesses that meet the requirements for SBA lending. They have the best interest rates and repayment terms.
There are SBA loans that demand collateral and others that don’t. The collateral requirements for loans are generally lower than those required for other types.
- A business line credit
A small business credit line is a form of revolving credit facility that has a predetermined credit limit. This allows you to withdraw capital as needed.
You may also be offered the credit option to use and repay the available credit, or even reuse it. After the draw period, you will begin making principal and interest payments.
- Credit cards for businesses
This type of credit is available to all business owners. To be authorized, you don’t have to have a good credit record or a minimum amount of annual income. Your credit history will determine whether or not you are approved for credit.
- Equipment financing
Because of the way small businesses are structured, equipment finance is possible for most. If you are purchasing a vehicle, or any other equipment for your startup, you can use it as collateral.
If the lender is unable to repay the debt, the lender may take collateral.
- Venture debt financing
If you have taken out equity financing and later find that you require additional funds, venture loan funding may be able to help bridge the gap. Venture lenders will search for funds to provide venture debt financing.
- Merchant cash advance
There are many forms of debt financing, including a merchant cash advance. Cash advances are the most costly form of financing. However, they can be very useful if your credit rating or time in business make them ineligible.
- Small business grants
Small business grants can provide additional financial resources without the need for repayment. Many government agencies and private corporations can offer grants of $500 to $50,000 to help your company grow or start up.
What situations would debt financing work for you
To decide if debt financing is the right business move, it’s important to ask yourself these questions:
- Which should I choose?
When the funds are used for fixed costs such as office furniture or equipment, direct cash returns on your loan funds are unlikely. This option will increase your debt load. You should also understand that installment payments will be made immediately after money is received. However, if you spend the money on variable costs such as inventory or supplies, it might result in a better cash flow.
- Which stage is my company at right now?
When you are just starting your business, it can be tempting for you to ask for money to help get your project moving. However, borrowing money is risky in the beginning stages of a business. In fact, 75% of all businesses lose money before becoming profitable. Your business credit rating can be adversely affected if you are unable to repay a loan.
- Do my customers pay on time?
You must keep your customers happy to stay in business. They should pay you on time so you can repay your loan. This is often not true. Pay attention to how your customers pay. It may be a good idea to offer financial incentives to encourage customers to pay earlier.
- Are my finances well-organized enough for consistent payments?
The truth is all around us! It is not an attribute of every business owner to be financially genius. It might be a sign that debt financing can prove to be dangerous, especially if you are fond of forgetting about repaying.
Benefits of Debt Financing
Debt financing has many advantages:
- This helps you keep control and ownership of your business
- Tax-deductible interest charges
- Interest rates reduced
The disadvantages of debt financing
- Regular paycheck is a requirement
- Credit ratings suffer from a significant decline
- Potential financial ruin
There is a difference between equity and debt financing
Working with lenders to finance debt involves borrowing money and paying interest. Equity financing is where capital is exchanged for equity or shares in your company.
Investors will examine your equity ratio before making any investment. This score allows investors to gauge your leverage when negotiating debt.
Nearly all businesses will require some form of loan financing. Additional funds are not only necessary for growth but also allow companies to invest in the resources they need to grow and develop. Small and new businesses need cash to purchase the essential equipment, inventory, machinery and supplies they require. You must ensure that you have sufficient cash flow to pay the principal and interest payments.