Debt financing will allow you to raise money for your business by selling debt instruments to investors. If you are looking to start or already own a small business, debt financing can help you gain the monetary resources you need to grow.
What is debt financing?
Debt financing is used to raise working capital for your business. By selling debt instruments, such as bank loans or bonds, your company will be able to raise money for your business. Debt financing will sometimes be referenced as financial leverage.
Individuals or large investors will lend the business money with the promise that the principal balance plus interest on the borrowed money will be repaid. Many businesses rely on debt financing to fund expenditures to allow the business to grow.
Debt financing is not equity financing. Unlike equity financing, debt financing preserves company ownership, as you are not selling public stock to raise funds.
How it works
There are a few different ways for companies to fund their businesses. For simplicity, this article will only focus on debt financing.
This process involves a company selling fixed-income products. Fixed income products are relatively secure forms of investment that promise to pay out money at a fixed rate – government bonds are the most common type of fixed-income securities. These products include bonds, bills, and notes.
The amount of investment must then be repaid in full, with the addition of interest payment, to each investor at a set time in the future. The terms of these loans may vary from long to short-term investments.
Things to consider
When deciding between the various ways to increase capital for your business, there are a few things to take into consideration when deciding if debt financing is right for you.
Cost of debt
When debts are issued, the company not only agrees to pay back the principal amount, but also the interest to them on a set schedule, whether that comes in yearly or monthly payments. The following formula should be used to determine the cost of debt financing to see if it is right for your company, where KD is equal to the cost of debt:
KD = Interest expense * (1 – Tax rate)
Because these interest payments are usually tax-deductible, the interest is calculated after taxes to determine the true cost of the debt.
The debt-to-equity ratio
Your debt-to-equity ratio is equal to your organization’s total debt divided by its total equity. In most cases, a low ratio is much better than a higher one – however, this is largely dependent on your industry.
Debt financing options
There are three common forms of debt financing that are often used by small businesses.
Bonds
Your business can issue small business bonds to your customers, investors, and more. This service is offered on a few different platforms for both small and medium-sized companies.
When issuing bonds, you agree to a set of repayment terms that sets a predetermined payback date as well as interest rates for the bonds. These bones have no other benefit to your business besides the loan amount – although, they can be good for communities, as they keep money within a set area typically.
In addition, these bonds are not selling any ownership of the company over to investors – unlike stocks, which allows the public part-ownership in the company.
Bank loans
Strong banking relationships, especially with local banks, will greatly help your company in the world of bank loans. Working with a bank is still a must in the world of starting and running a small business.
Banks will take a look at your credit rating, and perhaps also your personal credit history, business cash flow, tax returns, plans for the funds, and more before working out any loan terms, including interest rates, loan amounts, and more. In addition, most banks will require the use of collateral to secure the loan, this collateral can include the assets of the business or real estate properties, such as your home. Collateral offers additional security for the lender.
Small business administration loans
These are also known as SBA loans. The most common types of SBA loans include Economic Injury Disaster Loans (EIDL), SBA 7(a) loans, and SBA 504 loans.
EIDL programs help businesses in areas struck by natural disasters, such as hurricanes, fires, or other devastating community events. For example, the Small Business Administration (SBA) determined that the entire country was eligible for these loans after the onset of Covid. Money from these loans is meant to be used as working capital to meet your organization’s normal expenses.
The SBA 7(a) program is one of the most common small business loans they offer. They can be used for both short-term and long-term working capital, to purchase business supplies for operation, or even to refinance current debt. They are very useful in the world of real estate to help you finance new facilities.
SBA 504 loans are long-term, fixed-rate loans that can be used for major fixed assets. They must be used to finance items that promote business growth and create jobs. These loans have much stricter use terms, and cannot be used for debt refinancing, investing in rental properties, or for working capital.
SBA 504 loans have higher interest rates than the current market interest rates for the current five and ten-year U.S. Treasury bonds. These rates are automatically tied to a certain percentage above this set number.
Pros and cons of debt financing
Pros
- Preserves company ownership
- Tax-deductible interest payments
- Often is less expensive than equity financing
- Only requires the use of a small amount of capital to create growth
Cons
- Payments need to be made, despite the amount the business revenue
- This includes in the case of business failure
- Must pay interest to every lender
- Can be risky for businesses will inconsistent cash flows
- Can negatively impact credit score
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