What is Debt Financing?

Debt Financing

According to the U.S. Small Business Administration, newer businesses access capital from many different sources. More than 70% will use personal savings or another form of self-funding, while other sources include business loans, credit cards, venture capital, grants, and more. Debt financing is a traditional means of obtaining capital by borrowing with a repayment agreement. Roughly 87% of small business owners report they use some type of debt financing.

Understanding Debt Financing

Firms of all sizes often need funds for working capital and expenditures. To finance these operations, businesses often turn to two primary financing models: debt financing and equity financing, which involves giving up some ownership and control in a company in exchange for capital.

In debt financing, borrowers receive investment capital with the condition that they will repay the principal — the amount borrowed — and interest to compensate the lender.

Loans associated with debt financing may be secured or unsecured. A secured loan involves some form of collateral that provides some security for the lender. If the borrower is unable to repay the loan amount, the lender may use the collateral to recoup losses. One example is a mortgage loan where the lender uses the home as collateral. There are other types of securities that also reduce the risk for the lender.

More commonly, however, unsecured loans have no assets attached to them. A credit card is a perfect example of an unsecured loan.

Loan Guarantors

A loan guarantor is a third-party that contractually assumes the obligation to “guarantee” the repayment of a loan in the event that the borrower can’t. A newer small business will often have an insufficient credit history to satisfy the lender. In this situation, a credible guarantor will improve the borrower’s ability to obtain capital.

A cosigner is a guarantor who is needed to obtain approval for a loan. A cosigner is different from a co-borrower, but both are assuming the risk. A co-borrower has some shared interest along with the primary borrower, while a cosigner does not enter the agreement with the intentions of making the payments to satisfy the debt.

Understanding Equity Financing

An alternative to debt financing is equity financing, which involves issuing lenders some ownership of the business. Corporate entities often do this by issuing shares of stock. The lender providing an equity investment hope to see their share of ownership increase in value over time as the company grows.

One drawback from the owner’s perspective is they may be relinquishing some control to lenders that have an ownership interest. Companies that rely heavily on equity financing may have less flexibility to independently make moderate to large business decisions. There may be approval processes put in place such as when potentially adding employees or contracting with vendors.

Although this may seem like a very undesirable situation, the majority of large companies will require equity financing to fund their operations.

Debt Financing Through a Bank

Those who do not wish to surrender any management control to a lender often favor bank loans. Bankers do establish relationships with those they finance, but they are less likely to seek decision-making control in the business. Borrowers seeking financing may consider looking into several options from different banks to compare.

Repayment Periods

The repayment arrangement of a loan tends to be classified into one of three potential categories:

  • Short term: These are generally in the range of six to 18 months
  • Intermediate-term: Typically a range of one to three years
  • Long term: Any period that exceeds three years 

Other Potential Securities:

When obtaining loans for your business, lenders will often require you to provide collateral. There are a variety of assets that you can set up for security for your loans.

  • Invoices: A company’s accounts receivable are generally considered as viable. This includes any invoices that the company is awaiting payment on. Lenders advance approximately 60 to 80% of the value of accounts receivable.
  • Equipment: In what is called a chattel mortgage, a lender will view a company’s equipment, such as items used in manufacturing or production, as collateral. You can expect the collateral to equal roughly 60% of the equipment’s value 
  • Inventory: This usually equals approximately 50% of the value of products that are in-stock and available for sale. 
  • Real estate: Lenders generally view 90% of the value of the real estate as collateral.

Considerations When Choosing a Lender

A company that is seeking financing may place considerable emphasis on the speed in which lender can complete the process. This is particularly important when you are looking for a quick loan.

When looking to obtain capital fast, many business-owners consider using a credit card. A potential drawback is that credit cards may charge higher interest rates. The longer that you will need to pay the debt back, the more interest you will have to pay.

What is Tax Deductible?  

For tax purposes, debt financing loans are viewed as tax-deductible business expenses. The interest that you accrue will generally reduce your tax liability. This applies as long as the funds are used exclusively for business purposes. To be eligible for tax deductions, there must be a written, legal obligation that exists to repay the debt.

Working Capital

Most often a company seeks financing for the purpose of boosting its working capital, which is calculated by subtracting the company’s liabilities from its assets. Most business experts and investors consider working capital a good indicator of the financial strength of a business. A ratio of 2:1 between assets and liabilities is generally viewed as being strong, but this may not apply to all industries.

Often those who lack working capital will experience problems with cash flow. Timeliness is a significant factor when it comes to working capital. For instance, cash flow problems can arise if you have a slow-paying customer and expenses such as payroll or loan payments.

Debt to Equity Ratio

A potential lender will also likely want to calculate what your debt to equity ratio is. This is important for determining the financial strength of a company. Companies that are burdened by considerable debt will likely encounter difficulties in obtaining further credit.

Established Provider of Growth Capital Solutions

RevTek Capital is a lender offering emerging businesses revenue-based financing to support their growth. We partner with dynamic technology companies in various industries to assist them with obtaining the working capital they need.  For additional information, please visit our site or contact us at (480) 332-0399.

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