Whether you are a small, family-owned business or a large corporation, you will likely need an outside injection of capital to increase your cash flow. One of the most common ways to obtain that capital is with debt financing. So, what is debt financing?
The Basics of Debt Financing
Debt financing is where a business borrows money from another entity that they will later repay. In exchange for providing a line of credit, the lender will require payments on the principal — also known as the original amount — in addition to interest on the debt.
There are different ways that a business owner can obtain debt financing. On one hand, a larger business may be able to issue bonds to obtain the capital they need. More commonly, however, a bank or a similar entity will provide a business loan with specific terms, conditions on repaying the loan, and a designated interest rate.
Usually, debt financing is either used to make an acquisition or to finance general business expenses. Depending on the current market and the borrower’s credit rating, debt financing can be costly. The amount of interest paid throughout the duration of the loan is the cost of debt financing.
That cost is dependent on the interest rates, which change with the size of the loan. Generally speaking, a smaller loan translates to higher interest rates.
However, smaller interest rates on a larger loan still translates to more profit for the lender. Because of the larger overall reward, they are willing to charge less on annual interest.
What’s the Difference Between a Secured and Unsecured Loan?
There are two primary types of loans: secured and unsecured. An unsecured loan does not have any assets or security attached to it. As a result, an unsecured loan is riskier for the lender, which translates to higher interest rates. The most common type of unsecured loan is a credit card.
On the other hand, a secured loan has an asset or security attached to it. In the event that the debtor has a deficit in their balance sheet and cannot repay the debt, the lender can take hold of the asset.
A mortgage is an easy example of a secured loan because the lender can repossess the house if the lender doesn’t make their payments.
What Can Be Used for Security?
Lenders don’t restrict the security you provide for a secured loan to a physical asset. For businesses, there are a variety of securities you can put forward to obtain a secured loan and to receive a better interest rate as well.
- Guarantors: There are different options in this category, but in all of them someone contractually agrees to assume your debt if you default and can't pay it.
- Accounts receivable: This isn’t actually a tangible asset, but it is a commonly used security for businesses. Accounts receivable refers to the amount of money that customers or debtors currently owe you.
- Chattel mortgage: This is essentially the equivalent of a mortgage or car payment, where some tangible asset — such as equipment — is mortgaged to the borrower. The difference is that the borrower already owns the equipment and borrows against the value of the equipment.
- Real estate: Whether commercial or residential, most lenders will take about 90% of the value of your property as collateral.
What’s the Difference Between Debt and Equity Financing?
As you look to finance your business, there are several different financing models, especially for startups. One of the most common alternatives to debt that almost all businesses end up using is equity financing.
Whereas debt financing requires the borrower to repay the loan, equity financing involves the borrower giving up stock or ownership in their company in exchange for capital.
Most companies choose to implement both of these models to obtain the capital they need. There are different ideas about the exact debt to equity ratio a business should aim for, but most experts agree that a low debt to equity ratio is best.
Advantages and Disadvantages of Debt Financing
Debt financing can be extremely helpful, but it is not always the best option for you and your business. The most obvious con is the interest payments — whether to a bond holder or the bank that is providing the line of credit.
As previously mentioned, the monthly and overall impact of this interest varies depending on the amount of the loan. Regardless of the amount, all of the interest payments are tax deductible, which is a great benefit.
The main benefit to debt financing, however, is that you don’t have to give up any control or ownership in your business. Giving up shares in your company can cause conflict and prevent you from running the company the way you see fit.
What Does RevTek Offer?
We know that obtaining capital with favorable terms for your business can be difficult, if not impossible. That’s where our team at RevTek comes in.
Instead of getting stuck with rigid fixed debt payments or giving up ownership in your company, we offer flexible financing solutions that work for you. Revenue-based financing is the perfect solution for technology companies that generate most of their revenue from subscriptions.
If you are looking to obtain growth capital or move into a new market, contact us today.