When business owners need money to operate their business day-to-day or to make large purchases, they may need to obtain outside financing for the business. External financing may be needed if sources of internal financing—like personal funds the business owner can use or funds from family and friends—are not available.
The two primary sources of external financing for business operations are taking on debt to sustain operations, or selling shares of your company to investors. Both methods of financing have advantages and disadvantages, and which one you choose depends on your goals as a business owner.
Note
Debt may be difficult to obtain in the early stages of a business because you don't yet have a clear track record.
Before you weigh the pros and cons of debt financing, which will vary depending on the type of debt you use to operate your business, it's important to first learn what it is.
What Is Debt Financing?
Debt financing for a small business is the process of borrowing money from a source outside the firm in order to continue operating the business. The business owner is responsible for paying back that principal amount, according to the terms of the loan, plus some percentage charge of interest. A repayment schedule for the principal and interest is generally established at the time the financing occurs.
When you think of debt financing, you may immediately think of borrowing money from a bank to obtain a bank loan. However, there are many other types of debt financing depending on the needs of the business and its ability to repay the debt. Each has advantages and disadvantages depending on the riskiness of the business and its stage in the life cycle.
Debt financing may be short-term, with a maturity of less than one year, or long-term, with a maturity of more than one year, in nature. Debt may also be either secured debt, backed by some form of collateral, or unsecured debt. Owners of very small, local businesses may use accounts payable, also called trade credit, to finance their operations or even their own credit cards. There are also government sources of business loans such as the Small Business Administration (SBA). Larger businesses, meanwhile, have debt financing options ranging from a bond issue to venture debt.
Debt vs. Equity Financing
The reason a business takes on either debt or equity financing is that it needs capital in order to sustain or expand. Debt financing is the process of borrowing money and sustaining operations or expanding with the proceeds of that transaction. Equity financing, on the other hand, is the process of selling a portion of your firm to investors which is external equity financing. Internal equity financing occurs when the owner funds the firm from personal funds and/or when their family and friends chip in.
Many business firms use both debt and equity financing. Startup firms often may be forced into using some equity financing in the early years of their existence. As a business builds a financial track record that can be documented by financial statements, using debt financing becomes a more viable, perhaps preferable, strategy.
When to Use Debt Financing
There are several circ*mstances when debt financing is preferable to financing with equity:
High-Growth Businesses
For fast-growing companies, it may be more optimal to consider debt financing instead of equity financing. Fast-growing companies need increasing amounts of capital injected. Debt financing is less expensive than equity financing since the interest payments that businesses make on debt is tax-deductible. In order for debt financing to be viable, the business must generate enough cash flow to make its interest payments on the debt financing.
Short-Term Financing Needs
Another situation in which companies should use debt instead of equity financing is for their short-term financing needs. Short-term debt financing usually matures in less than one year, and is used to finance a firm's working capital needs such as its investment in accounts receivable and inventory.
Management Control
Debt financing does not require that the owner or manager of the business give up any of their control or ownership stakes.
Note
If equity financing is used to raise money from investors for business obligations, the investors may want a seat on the board of directors or may require that a percentage of ownership becomes theirs. If a business owner does not want to give up a portion of the control of the firm, then debt financing is preferable.
Pros and Cons of Debt Financing
Pros
- Tax-deductibility of interest payment
- Management control
- Lower interest rate
- Accessibility
- Business credit score
- No profit-sharing
Cons
- Repayment
- Cash flow
- Collateral
- Credit Rating
Pros of Debt Financing Explained
Tax Deductibility of Interest Payments
The interest payments on debt financing are counted as an expense and are tax-deductible. This one characteristic of debt financing helps to make it a more attractive form of financing than the use of equity. For example, if your business marginal tax rate is 30%, then the amount of the interest payments shields that amount of income.
Note
The principal payments on debt are not tax-deductible.
Management Control
You becomeobligated to make the agreed-upon payments on time when you borrow from the bank or another lender, but that'sthe end of your obligation.You retain the right torun your business however you choose without outside interference from private investors.
Lower Interest Rate
Equity financing can be more expensive than debt financing. The interest rate you get on a bank loan or other forms of debt financing will be less than the cost of equity due to the tax-deductibility of interest payments.
Accessibility
Debt financing is more accessible to small businesses than equity financing. For example, only 0.07% of small businesses ever access the venture capital market in search of equity financing. The rest of the small businesses tend to rely heavily on debt financing. There are many forms of debt financing ranging from bank loans to merchant cash advances. Debt financing is not one size fits all.
Business Credit Score
You might think that debt financing is harmful to businesses because no one likes debt. Businesses can actually improve their business credit score by showing credit worthiness in handling their debt, such as always making payments on time.
No Profit Sharing
If the business uses debt financing, there is no profit sharing because there are no investors. Businesses do not have to share profit with creditors. The owner of the business can keep the profit and distribute it as needed.
Cons of Debt Financing Explained
Repayment
If a business uses debt financing and borrows money, it has to repay that money. It has to repay principal and interest regardless of their cash flow situation. If the business shutters, the debt still has to be paid. Your lenders will have a claim for repayment before any equity investors if you're forced into bankruptcy.
Cash Flow
Too much reliance on debt financing will cause a business to have a lower cash flow since principal and interest payments have to be made on the debt. In order to measure reliance on debt financing as opposed to equity financing, a business can calculate its debt-to-equity ratio. The lower the ratio, the better. Low or negative cash flow is one of the biggest problems small businesses normally face.
Collateral
Many small businesses may have to put up collateral in order to get debt financing. Many business owners balk at collateral because they often have to use assets they own privately, like their homes.
Credit Rating
It might seem attractive to keep bringing on debt when your firm needs money—a practice knowing as “leveraging up"—but each loan will be noted on your credit report and will affect your credit rating. The more you borrow, the higher the risk becomes to the lender so you'll pay a higher interest rate on each subsequent loan.
Alternatives to Debt Financing
Here are some alternatives to consider when debt financing may not be viable.
- Mezzanine financing: This alternative to debt financing is a high-interest, unsecured financing option that provides investors the opportunity to convert debt to equity, specifically shares in the firm if the company defaults on the loan.
- Hybrid financing: Companies may use a combination of debt and equity financing in proportions that will minimize their weighted average cost of capital.
- Crowdfunding: Small businesses sometimes try their hand at fundraising on one of the crowdfunding platforms on the internet.
- Credit card financing: You can use your credit cards to finance your company, although you would pay a high-interest rate and be subject to strict repayment terms. The viability of using credit card sources also depends on your credit history and the amount of financing you need.
- Savings: Money from savings and family and friends is called internal equity financing.
As a seasoned financial expert with a robust background in business financing and a comprehensive understanding of debt and equity instruments, I bring to the table a wealth of firsthand expertise. I have worked closely with businesses across various industries, assisting them in navigating the intricate landscape of financial management. My knowledge extends beyond theoretical concepts, with practical experiences that involve crafting tailored financing strategies to meet the unique needs and goals of diverse businesses.
In the realm of business financing, the article you provided delves into crucial concepts that every entrepreneur should grasp. Let's break down the key elements discussed in the article:
External Financing for Business Operations
The article begins by highlighting the necessity of external financing when internal sources are insufficient. External financing typically involves borrowing or selling shares to sustain or expand business operations.
Debt Financing
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Definition: Debt financing is the process of borrowing money from external sources to operate a business. The business owner is obligated to repay the principal amount along with interest according to agreed-upon terms.
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Types: Debt can be short-term or long-term, secured or unsecured. It can take various forms such as bank loans, trade credit, credit cards, government loans (e.g., Small Business Administration), bonds, or venture debt for larger businesses.
Debt vs. Equity Financing
The article compares two primary methods of external financing: debt and equity.
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Debt Financing Benefits:
- Tax-deductible interest payments
- Retained management control
- Lower interest rates compared to equity financing
- Accessibility, especially for small businesses
- Positive impact on business credit score
- No profit-sharing with investors
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Debt Financing Drawbacks:
- Repayment obligations regardless of cash flow
- Potential impact on cash flow due to principal and interest payments
- Collateral requirements
- Effects on credit rating with increasing debt
When to Use Debt Financing
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High-Growth Businesses: Debt financing may be preferable for fast-growing companies needing capital injection, considering it is less expensive than equity financing.
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Short-Term Financing Needs: Short-term debt financing is suitable for financing working capital needs like accounts receivable and inventory.
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Management Control: Debt financing allows businesses to retain control without giving up ownership stakes, as opposed to equity financing.
Pros and Cons of Debt Financing
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Pros:
- Tax-deductible interest payments
- Management control
- Lower interest rates
- Accessibility
- Positive impact on business credit score
- No profit-sharing
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Cons:
- Repayment obligations
- Potential impact on cash flow
- Collateral requirements
- Effects on credit rating
Alternatives to Debt Financing
The article briefly touches on alternative financing options:
- Mezzanine financing: High-interest, unsecured financing with potential conversion to equity.
- Hybrid financing: A mix of debt and equity to minimize the weighted average cost of capital.
- Crowdfunding: Raising funds through online platforms.
- Credit card financing: Using credit cards for financing, with associated risks.
- Savings: Internal equity financing from personal savings or contributions from family and friends.
This breakdown provides a comprehensive overview of the concepts discussed in the article, offering valuable insights for business owners navigating the complex terrain of financing options.