Every business owner needs financing in one form or another at some point. Whether you need new equipment or money for payroll, you have a variety of options.
Debt financing is the act of borrowing money to help fund your business, and there are many types available. The two broader categories are long and short-term. Here we will cover the advantages and disadvantages and answer the question “what is debt financing?”
How Does Debt Financing Work?
Depending on the type of financing you are seeking, the debt financing definition will change, and the avenue of debt financing that you use will be categorized as either long-term or short-term.
Long-Term Debt Financing
Long-term financing typically applies to assets, such as equipment or real estate. The assets you purchase act as collateral for the loan in most cases. This is particularly true for equipment loans, which can be used to purchase anything from restaurant furniture to industrial machinery. The average length of a long-term loan is between three and seven years. However, the Small Business Association sometimes provides terms up to 10 years. Consistent monthly payments with fixed interest rates provide stability for your budget.
Short-Term Debt Financing
Short-term financing is commonly attributed to daily needs, such as supplies, payroll, inventory, and cash. Short-term loans or lines of credit are often repaid within a single year and are great sources for businesses that struggle with cash flow issues. Credit cards are another popular short-term financing solution, but these come with a wide variation of interest rates and fees.
What Are the Types of Debt Financing?
Depending on your goals, your financing strategy could be multi-layered and compromise more than just one single form of debt financing. Here are a few of the primary types:
- Bonds are very similar to loans, but the capital comes from investors that buy bonds issued by a company or government agency. The company then pays out interest, usually annually or semi-annually.
- Equipment loans are issued specifically for purchasing equipment. They are easier to access because the equipment you purchase functions as the collateral.
- Equipment leases are also used specifically for purchasing equipment. Equipment leasing allows for less upfront costs and more flexibility than other financial options.
- Cash flow lending is a type of loan that uses a company’s cash flow statements to assess risk and determine eligibility rather than assets. They will likely ask you to supply extensive business and financial records to show your transaction frequency, sales, return rates, expenses, and more.
- Credit cards are a staple form of debt financing that most businesses and individuals carry. They are generally very easy to get, but the available limit is mostly determined by your credit history.
- Home equity loans are comparable to a mortgage. You receive a cash infusion that is paid back through a fixed monthly rate.
- A line of credit is similar to a credit card. You are awarded a borrowing limit that you can access whenever you need it, and you only pay interest on the amount you withdraw.
- Family or friend loans are commonly used by start-ups because the terms are not as strict. Standard loans almost always require a business to have at least one year in operation and good credit history. You can mostly bypass that by having your family and friends invest in your company.
- Peer-to-peer lending can be accessed through online platforms where lenders with a special interest in your industry can invest in your company.
- Financial institution loans are your standard term loan. They usually have good terms, but there is a strict set of requirements you must meet in order to be eligible.
Banks and other lenders have different requirements to qualify for each of the aforementioned options. As a borrower, it is in your best interest to shop around for the best option.
What Are the Advantages of Debt Financing?
One of the greatest advantages of debt financing is that businesses do not have to sell shares of their company to get capital. Some other advantages include:
- Many forms of debt financing offer low interest.
- Not all debt financing options are expensive, which is important for small businesses who need a type of debt that does not cut into cash flow or cause issues with daily operations.
- It allows you to build your business credit history to make long-term loan options with lower costs available to your business in the future.
- Long-term debt lessens your exposure to more costly debt.
- Debt can create growth. With financing, you can hire more staff, create more products, and spend more money on branding and marketing.
- This type of financing is tax-deductible because it is classified as a business expense.
Debt may seem like a scary word, but most companies find it absolutely necessary to acquire debt in order to grow.
What Are the Disadvantages of Debt Financing?
Of course, there are some drawbacks to debt financing. For example:
- You have to repay the lender even if your venture fails.
- You need collateral for nearly every form of debt financing. If you do not have business collateral, lenders will need you to supply a personal guarantee, usually in the form of a major personal asset. The amount you need to provide is related directly to the amount of the loan.
- Some lenders rope in small businesses with appealing promises and they charge them high rates that were written in the small text.
- Loans are noted on your credit history. While they can help you grow your credit over time, they can also negatively impact your credit if you are ever in default.
Do not let the negative connotations surrounding the word debt deter you from getting the funds you need to build your business. Create a business plan and shop around for the best lenders. For more information on debt financing, speak with an expert at Platform Funding today.