What Is Debt Financing?
Debt financing is a method of raising funds for a business by borrowing money from lenders, such as banks or investors, who expect to be repaid with interest over a specified period of time. It involves taking on debt in the form of loans or bonds rather than selling ownership in the company to investors. Selling ownership in the company is another method of financing referred to as equity financing. Debt financing is a major component of scaling small businesses.
Key Takeaways
- Debt financing is a method of raising funds for a business by borrowing money and repaying the principal with interest over a specified period of time.
- Equity financing means selling a part of ownership in the company in exchange for money. In contrast, debt financing means borrowing money that must be paid back with interest.
- High levels of debt financing were common in the years following the 2007–2008 financial crisis due to very low-interest rates. However, as interest rates rise, businesses must prepare for a greater cost of debt.
- Debt financing allows business owners to maintain control over their business, unlike equity financing, which cedes some control to investors.
- Business owners receive a tax deduction on the interest they pay on their debt financing.
How Debt Financing Works
Here is a breakdown of how debt financing typically works for small businesses:
- Determine the amount of capital needed: The business owner must determine how much money they need to borrow to meet their financial needs, such as purchasing inventory, expanding their operations, or paying off existing debts.
- Shop around for lenders: Next, the owner can shop around for lenders who offer the best terms, rates, and repayment options. It’s important to compare and contrast different lenders to find the best fit for the business.
- Submit a loan application: The business owner must complete and submit a loan application. The application will include details about the business, the loan amount, the purpose of the loan, and the repayment plan.
- Await approval and funding: The lender will review the loan application. They’ll also assess the creditworthiness of the business owner and the business.
- Repay the loan with interest: The business owner must repay the loan amount over time with interest. The terms of the loan, including the interest rate and repayment schedule, will be outlined in the loan agreement.
The Difference Between Equity and Debt Financing
Equity financing means selling a part of ownership in the company in exchange for money. On the other hand, debt financing means borrowing money that must be paid back with interest.
The main difference between equity and debt financing is that with equity financing, investors become part owners of the company and share in its profits and losses. In contrast, with debt financing, the company remains the sole owner but has to pay back the borrowed money with interest. The risks involved in equity financing are primarily loss of control. However, the risks involved in debt financing are primarily financial.
Types of Debt Financing
Debt financing can be either short-term or long-term. Corporate debt can take any of the following forms:
- Revolving loans: This type of loan allows borrowers to access funds as needed, up to a pre-approved limit, similar to a credit card. As the borrower repays the borrowed funds, the available credit limit resets, allowing them to borrow again. Revolving loans are generally used for short-term expenses. However, this is not considered a short-term or long-term loan because the borrower can repay the loan or take it out again at the end of every period.
- Cash flow loans: A cash flow loan is a type of debt financing based on the borrower’s projected cash flow. The lender assesses the borrower’s ability to repay the loan by analyzing their revenue, expenses, and accounts receivable. Cash flow loans are typically short-term loans.
- Installment loans: An installment loan is a loan that is repaid in regular installments over a fixed period of time. The borrower receives the full amount of the loan upfront and then repays the loan in fixed payments until they have fully repaid the loan. Mortgages, car loans, and student loans are all examples of installment loans. This type of loan can be either short or long-term.
What Do the Experts Say?
Celebrity investor Mark Cuban says using debt to start a business is extremely risky. He says, “There are so many uncertainties involved in starting a business. Yet the one certainty you’ll have is paying back your loan. And the bank doesn’t care about your business.”
According to Cuban, you should only use debt financing when you’ve already established that you can produce revenue.
Tim Francis, owner of the entrepreneurship education company Profit Factory explains that owners must use debt very carefully. He says, “Debt isn’t necessarily good or bad. Debt is an instrument. It’s like a knife. It can protect you and keep you safe or it can badly, badly injure you.”
Francis believes debt comes with a lot of responsibility. Business owners must carefully consider the consequences when using debt financing.
“Debt accelerates what’s already happening, whether it’s good or bad,” Francis continues. “What you’ll typically find is that in an upmarket, debt can be your best friend. Because it helps you to invest more heavily into advertising and production. And because the whole market is going up, now you get to capitlize on more and more customers and more and more sales. Debt, on the other hand, in a down economy actually accelerates your demise. Debt is your friend on the way up, and it’s your enemy on the way down.”
Frequently Asked Questions About Debt Financing
What are some examples of debt financing?
- Bank loans: There are many types of bank loans a company can use to finance their business, including small business loans, short-term loans, and startup loans. Banks often provide cash flow loans, installment loans, and revolving loans.
- Factoring: Invoice factoring is when a business sells its unpaid invoices to a company for less than the invoices are worth. The company buying the invoices gives the business cash up front and then collects payment from the customers on the invoices.
- Bonds: Bonds are a type of debt financing that works like an IOU. When you issue a bond, you’re borrowing money from investors for a set amount of time, and in exchange, you’ll pay interest at a predetermined rate. At the end of the bond term (known as the maturity date), you will repay the principal amount of the bond.
- Credit cards and lines of credit: Credit cards and other lines of credit are a type of revolving loan that many businesses use to cover short-term expenses.
- Loans from family and friends: Loans from family and friends can be short- or long-term, and the interest rate is whatever you agree upon with the lender.
- Real estate loans: A real estate loan is a type of installment loan that allows business owners to finance the purchase of a new commercial property or renovate a property they already own.
Is debt financing a loan?
Loans are one of the most common types of debt financing. However, other types of debt financing include credit cards and bonds.
Is debt or equity financing better?
The best way to finance your business is to use a mix of equity and debt financing. However, if you’re deciding whether focusing more heavily on debt financing is a good decision, here are some things to consider:
Pros
- Tax Benefits: A major advantage of debt financing is that the interest paid on business debt is tax deductible, which can help reduce the cost of debt.
- Retain Ownership: Unlike equity financing, businesses using debt financing do not have to give up ownership or control of the company. The lender has no ownership stake in the business and has no say in business decisions.
- Predictable Payments: The terms of the loan are typically fixed, so the business knows exactly how much it needs to pay back each month, making it easier to plan and budget.
Cons
- Interest Payments: The biggest downside of debt financing is that the business will have to pay interest on the loan, which can be a significant expense over time. Businesses must keep up with interest payments regardless of how much revenue they bring in. This could become difficult if a business has a period of low revenue.
- Risk of Default: If the business cannot make its loan payments, it could default on the loan, which can cause damage to the business’s credit score, legal action, loss of collateral, and even bankruptcy.
- Difficulty Qualifying: Debt financing can be beneficial if your business is new and doesn’t have a strong credit history. But it may be difficult to find lenders willing to offer a good interest rate and loan terms.
Important
Following the 2007–2008 financial crisis, interest rates on corporate debt were very low, making debt financing seem like the obvious choice. Many business leaders were able to scale their companies through debt financing while paying very little interest to lenders.
However, in 2023, interest rates have quickly risen, making it more difficult to finance business growth with debt. If you choose to grow your business through debt financing, keep in mind that the cost will be higher than it was for the past decade. It’s important to maintain a consistently high cash flow to be able to cover your interest payments.
Maintain a Healthy Debt-to-Equity Ratio While Growing Your Business
The debt-to-equity ratio (D/E) measures an organization’s leverage by dividing total debt by shareholder’s equity. Calculate your company’s D/E ratio when making decisions about debt and equity financing to ensure you’re maintaining a healthy level of debt.
A debt-to-equity ratio between zero and one indicates a low-risk business. However, although your D/E ratio should be low, it’s important to use some amount of debt financing to grow your business. While some business owners believe they should try to get out of debt, don’t let your fear of debt keep you from achieving your potential.
According to Warren Buffett and the Interpretation of Financial Statements, Buffett prefers investing in companies with a ratio below 0.5. If your D/E ratio is near that number, you are likely using a great balance of debt and equity financing as you scale your company.
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