When business owners need money to operate their business day-to-day or to make large purchases, they may need to obtain outside financing for the business. External financing may be needed if sources of internal financing—like personal funds the business owner can use or funds from family and friends—are not available.
The two primary sources of external financing for business operations are taking on debt to sustain operations, or selling shares of your company to investors. Both methods of financing have advantages and disadvantages, and which one you choose depends on your goals as a business owner.
Debt may be difficult to obtain in the early stages of a business because you don't yet have a clear track record.
Before you weigh the pros and cons of debt financing, which will vary depending on the type of debt you use to operate your business, it's important to first learn what it is.
What Is Debt Financing?
Debt financing for a small business is the process of borrowing money from a source outside the firm in order to continue operating the business. The business owner is responsible for paying back that principal amount, according to the terms of the loan, plus some percentage charge of interest. A repayment schedule for the principal and interest is generally established at the time the financing occurs.
When you think of debt financing, you may immediately think of borrowing money from a bank to obtain a bank loan. However, there are many other types of debt financing depending on the needs of the business and its ability to repay the debt. Each has advantages and disadvantages depending on the riskiness of the business and its stage in the life cycle.
Debt financing may be short-term, with a maturity of less than one year, or long-term, with a maturity of more than one year, in nature. Debt may also be either secured debt, backed by some form of collateral, or unsecured debt. Owners of very small, local businesses may use accounts payable, also called trade credit, to finance their operations or even their own credit cards. There are also government sources of business loans such as the Small Business Administration (SBA). Larger businesses, meanwhile, have debt financing options ranging from a bond issue to venture debt.
Debt vs. Equity Financing
The reason a business takes on either debt or equity financing is that it needs capital in order to sustain or expand. Debt financing is the process of borrowing money and sustaining operations or expanding with the proceeds of that transaction. Equity financing, on the other hand, is the process of selling a portion of your firm to investors which is external equity financing. Internal equity financing occurs when the owner funds the firm from personal funds and/or when their family and friends chip in.
Many business firms use both debt and equity financing. Startup firms often may be forced into using some equity financing in the early years of their existence. As a business builds a financial track record that can be documented by financial statements, using debt financing becomes a more viable, perhaps preferable, strategy.
When to Use Debt Financing
There are several circumstances when debt financing is preferable to financing with equity:
For fast-growing companies, it may be more optimal to consider debt financing instead of equity financing. Fast-growing companies need increasing amounts of capital injected. Debt financing is less expensive than equity financing since the interest payments that businesses make on debt is tax-deductible. In order for debt financing to be viable, the business must generate enough cash flow to make its interest payments on the debt financing.
Short-Term Financing Needs
Another situation in which companies should use debt instead of equity financing is for their short-term financing needs. Short-term debt financing usually matures in less than one year, and is used to finance a firm's working capital needs such as its investment in accounts receivable and inventory.
Debt financing does not require that the owner or manager of the business give up any of their control or ownership stakes.
If equity financing is used to raise money from investors for business obligations, the investors may want a seat on the board of directors or may require that a percentage of ownership becomes theirs. If a business owner does not want to give up a portion of the control of the firm, then debt financing is preferable.
Pros and Cons of Debt Financing
- Tax-deductibility of interest payment
- Management control
- Lower interest rate
- Business credit score
- No profit-sharing
- Cash flow
- Credit Rating
Pros of Debt Financing Explained
Tax Deductibility of Interest Payments
The interest payments on debt financing are counted as an expense and are tax-deductible. This one characteristic of debt financing helps to make it a more attractive form of financing than the use of equity. For example, if your business marginal tax rate is 30%, then the amount of the interest payments shields that amount of income.
The principal payments on debt are not tax-deductible.
You become obligated to make the agreed-upon payments on time when you borrow from the bank or another lender, but that's the end of your obligation. You retain the right to run your business however you choose without outside interference from private investors.
Lower Interest Rate
Equity financing can be more expensive than debt financing. The interest rate you get on a bank loan or other forms of debt financing will be less than the cost of equity due to the tax-deductibility of interest payments.
Debt financing is more accessible to small businesses than equity financing. For example, only 0.07% of small businesses ever access the venture capital market in search of equity financing. The rest of the small businesses tend to rely heavily on debt financing. There are many forms of debt financing ranging from bank loans to merchant cash advances. Debt financing is not one size fits all.
Business Credit Score
You might think that debt financing is harmful to businesses because no one likes debt. Businesses can actually improve their business credit score by showing credit worthiness in handling their debt, such as always making payments on time.
No Profit Sharing
If the business uses debt financing, there is no profit sharing because there are no investors. Businesses do not have to share profit with creditors. The owner of the business can keep the profit and distribute it as needed.
Cons of Debt Financing Explained
If a business uses debt financing and borrows money, it has to repay that money. It has to repay principal and interest regardless of their cash flow situation. If the business shutters, the debt still has to be paid. Your lenders will have a claim for repayment before any equity investors if you're forced into bankruptcy.
Too much reliance on debt financing will cause a business to have a lower cash flow since principal and interest payments have to be made on the debt. In order to measure reliance on debt financing as opposed to equity financing, a business can calculate its debt-to-equity ratio. The lower the ratio, the better. Low or negative cash flow is one of the biggest problems small businesses normally face.
Many small businesses may have to put up collateral in order to get debt financing. Many business owners balk at collateral because they often have to use assets they own privately, like their homes.
It might seem attractive to keep bringing on debt when your firm needs money—a practice knowing as “leveraging up"—but each loan will be noted on your credit report and will affect your credit rating. The more you borrow, the higher the risk becomes to the lender so you'll pay a higher interest rate on each subsequent loan.
Alternatives to Debt Financing
Here are some alternatives to consider when debt financing may not be viable.
- Mezzanine financing: This alternative to debt financing is a high-interest, unsecured financing option that provides investors the opportunity to convert debt to equity, specifically shares in the firm if the company defaults on the loan.
- Hybrid financing: Companies may use a combination of debt and equity financing in proportions that will minimize their weighted average cost of capital.
- Crowdfunding: Small businesses sometimes try their hand at fundraising on one of the crowdfunding platforms on the internet.
- Credit card financing: You can use your credit cards to finance your company, although you would pay a high-interest rate and be subject to strict repayment terms. The viability of using credit card sources also depends on your credit history and the amount of financing you need.
- Savings: Money from savings and family and friends is called internal equity financing.