Debt Financing: Understand Your Options, the Pros, and the Cons
About one in three small businesses apply for debt financing every year. Entrepreneurs use this funding to shore up working capital, purchase and renovate real estate, revive inventory levels, open new premises, and much more.
In this article, we cover:
What debt financing is
The different forms of debt financing
The alternatives to debt financing available to small businesses
The pros and cons of using debt financing for your business
What Is Debt Financing?
Debt financing is when you borrow against your company’s anticipated future cash flows and earnings. This is just like how consumers borrow against their anticipated future wages to buy a house or a car.
Let’s say you have an embroidering business. Sales are going really well, but you’re getting really close to capacity. In other words, the amount of goods you can sell will exceed the capacity your machinery or personnel can fulfill.
You have two options. First, you could wait for a future date when you’ve built up the cash in the bank to pay for a second piece of equipment and employ the staff needed to operate it.
Or you can take advantage of the rising demand and use debt financing to fund the purchase of new equipment and cover the first few months’ wages of the staff who’ll operate it.
Many choose the latter so they can take advantage of the extra sales and grow their market share.
You may apply for short-term or long-term debt financing with your lender. Definitions vary, but most lenders classify long-term debt as debt where the period of time to make repayment in full is more than 12 months.
What Types of Debt Financing Are Available?
There are two main types of debt financing: term loans and non-term loans.
With a term loan, your lender agrees to forward you a certain amount of cash, and you agree to certain repayment terms.
For example, you may borrow $100,000 through a five-year term loan. In this case, you will need to make regular monthly payments for five years (or 60 months) to your lender to repay the debt. These repayments are also known as installments.
Each installment will have two parts: the capital you owe (paying off what you actually borrowed) and the interest (the cost of borrowing the money).
The most popular types of term loan debt financing include but are not limited to:
Standard business loans: This is the type of loan you might take out to buy new equipment, expand to new premises, and so on.
Commercial mortgages: Small business owners use commercial mortgages to pay for buildings and land, similar to homeowner mortgages. Sometimes, a borrower will ask for more to make renovations or changes to the building or land.
Working capital advance: These loans are popular with businesses that may be experiencing a lull in available cash due to a seasonal downturn in sales or an unexpected business expense.
Merchant cash advances: This is a niche type of finance where you borrow an agreed amount of money and make repayments on your loan via your credit and debit card sales.
Non-term loans are more often referred to as business lines of credit.
This is how they work. Let’s say that your lender gives you a limit on your line of credit of $100,000. One month, you withdraw $20,000 from your limit to pay for inventory. In this situation, you’d have a balance of $20,000, and you’d still have $80,000 available for withdrawal.
With a line of credit, you’ll only make monthly repayments on the portion that you’ve withdrawn. In most cases, you won’t owe the full amount at once and can make installment payments. Any amount you pay back then becomes available for withdrawal again.
In the above example, if you pay back $10,000 of the $20,000 you withdrew, your balance would be $10,000, and you’d now have $90,000 available for withdrawal.
Just like with term loans, there is a cost of debt, usually expressed as an interest rate, but only on your balance (or the amount you’ve withdrawn). This is different from term loans where you pay interest on the entire amount of the loan.
In addition to lines of credit, other types of non-term loan debt financing include:
Business credit cards: They operate in the same way as personal credit cards but often offer much higher balances.
Business overdrafts: With a business overdraft, you can withdraw more money from your account than is available in it. You normally pay a facility fee for an overdraft plus interest on the amount you're overdrawn by.
Invoice factoring: Sometimes called “accounts receivable loans,” this is when you sell your unpaid invoices to a lender. They then pay you up to 90% of the value of the invoice within 24 hours. You get the remainder minus a factoring fee when your client pays up.
What Do Lenders Want to See in an Application for Debt Financing?
The eligibility requirements when applying for debt financing vary from lender to lender.
In general, most traditional lenders look for:
A healthy balance sheet: If you can show a good mix of assets on your balance sheet as well as manageable liabilities, this indicates to a lender that you’re more likely to be able to repay what you borrow.
Good cash flow management: Lenders will often ask to see your bank statements to see how well you manage money currently.
Existing profitability: You’ll have to show that the business you’re operating is profitable or that you have a very high, justifiable expectation that profitability is around the corner.
A convincing business plan: Making repayments puts additional strains on your cash flow. If you’re expanding, you may have other higher fixed costs like rent and wages. You’ll need to show where the money will be coming from to make repayments.
A good credit history: When making small business loans or credit facilities available, lenders may struggle to approve your application if your business score is below 80 or your personal credit score is below 680. The general rule of thumb is that a better credit score and credit history will lend to better chances of approval and lower interest rates.
What Options Are Available for Businesses That Don’t Meet Standard Eligibility Criteria?
Not every business will meet the criteria laid down by traditional lending providers. Startups in particular struggle to qualify.
Some newer financial institutions or alternative lenders require less paperwork. And although they may have higher interest rates, you may be able to get access to the money more quickly. For example, Backd is an alternative lender with a 24-hour turnaround time upon approval.
You may also wish to consider applying for an SBA loan. These loans are a partnership between private lending institutions like banks and the U.S. Small Business Administration. The loan amounts you can apply for are similar to if you applied to a private lender directly.
What Alternatives Are There to Debt Financing?
There are other routes you can take to access cash for your business, including:
Private equity financing and venture capital: This is where you give up a percentage of your shareholding (sometimes called “dilution”) in exchange for investment. Occasionally, an investor may wish to have a seat on your board and influence over decision-making.
Seeking an active partner: A variation on the above, you could approach an investor or competitor to invest in your company. This would also involve giving away shares, but you would have access to your partner’s expertise, connections, labor, and customer base.
Crowdfunding: Sites like Indiegogo and Kickstarter allow you to raise funds from investors by recruiting believers in your project. You can either repay them with equity or via a reward program.
Business grants: You can apply for grants at city, state, and federal levels and not have to make any repayments at all. There is a lot of competition for grants, however, and the amount of funding via these channels is limited.
Pros and Cons of Debt Financing
As with all major business decisions, there are upsides and downsides to taking out debt financing for your business.
Advantages of Debt Financing
The benefits that may persuade you to take out debt financing include:
Tax-deductible repayments: Interest payments on your loan as well as origination costs like broker fees can be deductible for tax purposes.
Overall control: Lenders do not require a seat on the board or share dilution. You remain in control, and your only responsibility to your lender is to meet the repayment terms you agreed to.
Better business credit: Most lenders report on borrower behavior to credit bureaus once a month. If you manage your facility well, you’ll be able to improve your credit.
Disadvantages of Debt Financing
Some of the disadvantages of debt financing include:
Early repayment penalties: If you find yourself in a position to partly or wholly clear your facility ahead of time, your lender may penalize you for this with additional charges.
Higher fixed costs: You will have to budget to make repayments on your facility each month. This will push up your overall expenses, and you may need to make extra sales to cover it.
Collateral and guarantees: Many lenders require you to offer assets that they can seize and sell to recoup an outstanding balance if you can’t make repayments. If the proceeds of the sale don’t cover the balance in full, your lender may pursue you personally for the money.
Use Backd for Fast and Flexible Debt Financing Options
Debt financing is and will remain a popular source of funding for small businesses wanting to grow or protect their cash flow during more turbulent economic times. There is a wide range of options available.
Backd is a leading provider of debt financing to small businesses. Unlike many lenders, we appreciate that time is of the essence. We know you want a quick answer and, if the answer is “yes,” fast remittance of the funds.
If you want a working capital advance of up to $2 million or a business line of credit of up to $750,000, we can turn your application around in just 24 hours. We don’t ask for collateral or make you sign a personal guarantee either.
Apply with Backd today — it only takes a few minutes.