What is Debt Financing?
In simple terms, debt financing is when a small business borrows money from a third party with the agreement to pay back the total sum plus a predetermined amount of interest. Small businesses may need debt financing for several reasons, including hiring new staff, buying extra inventory or equipment, or making unexpected repairs to a facility. It’s a convenient way to fund unplanned expenses that aren’t included in the business’s original budget. There are a few different ways that these businesses can get debt financing, including microloans, business loans, credit cards, bank loans, or peer-to-peer loans. If a company needs an influx of cash, it’s reassuring to know that there are options available to supplement its current budget. Of course, when borrowing money in any capacity, there are pros and cons to consider. Let’s discuss those next.Pros of Debt Financing
Keep Ownership of Business
When choosing debt financing through a traditional bank rather than an individual investor, business owners can maintain more control over the daily operations of their business. While investors may lend money on the condition that they have a say in how the business is operated, banks and other financial institutions usually aren’t concerned with this type of thing. With traditional debt financing, business owners control the direction of the business and get to continue their autonomy over day-to-day operations.
Tax Deductions
The principle and interest payments made towards debt financing can count as business expenses – meaning that these installments can be deducted from business income taxes. This can be an excellent way for business owners to reduce the amount of money they must pay in taxes for the year.
Lower Interest Rate
This concept can be somewhat complicated, so it’s crucial that small business owners talk with their accountants to fully understand the benefits of lower interest rates with debt financing. There can be a tax advantage for small businesses when they take on debt, but the actual amount of these advantages depends on the current percent interest of the debt and the business’s tax rate from the government. These lower interest rates can be very beneficial for companies because they get the money that they need and have a chance to lower the interest on their payments.
Ease in Planning Payments
There are no surprises or guesswork in payments with debt financing. Banks and other institutions will clearly outline an agreed-upon payment schedule that outlines when payments will be made and how much will be paid. This arrangement allows businesses to easily budget payments without concern about paying more than anticipated.
Cons of Debt Financing
Paying Back Debt
When taking out a loan for debt financing, it goes without saying that the business will have to pay the loan back over time. (There’s no such thing as free money.) While companies know this before taking out a loan, there is always a chance that the business may not bring in the income that they expected. If a company is not doing well or isn’t getting the anticipated customer traffic, paying the debt can be a challenge.
High Interest Rates
Depending on the bank or financial institution, the reason for the loan, and the credit history of the business taking out the loan, interest rates for debt financing can be relatively high. Borrowing money is expensive, so it’s important to shop around for the best rate after deciding to participate in debt financing.
Cash Flow Challenges
Paying back installments can create cash flow problems. In seasons of lower income or slow business, small businesses may have difficulty managing their loan payments. Obviously, companies should make well-thought-out decisions and refrain from taking out loans if they are unsure whether they can pay them back; however, this is still a helpful point to keep in mind.
Credit Rating Impacts
Debt financing can be either good or bad for business credit, depending on how it is handled. For business owners who pay their installments on time, these loans can improve their credit rating. However, consistently missing payments can be detrimental to credit. Additionally, borrowing a large sum of money without adequate credit history can also reduce credit rating.
Debt financing can be a helpful tool for many businesses when it is managed properly. If you are considering debt financing for your own small business, make sure that you do the proper research, borrow only what you can afford, and talk to your accountant about some potential business risks and benefits.
