Find out more about debt financing, how it works, and the advantages and disadvantages of using this method to run your business.
Definition and Examples of Debt Financing
Debt financing is what happens when a business borrows money in order to operate, rather than raising money from investors—which is called equity financing. Some examples of debt financing include:
Traditional bank loansPersonal loansLoans from family or friendsGovernment loans, including Small Business Administration (SBA) loansPeer-to-peer loansHome equity loansLines of creditCredit cardsEquipment loansReal estate loans
How Debt Financing Works
You can think of debt financing as being divided into two categories based on the type of loan you’re seeking: long-term and short-term.
Long-Term Debt Financing
Long-term debt financing generally applies to assets your business is purchasing, such as equipment, buildings, land, or machinery. A lender will normally require that long-term loans be secured by the assets to be purchased. With long-term debt financing, the scheduled repayment of the loan and the estimated useful life of the assets often extends for three- to seven-year terms. Loans guaranteed by the SBA can provide terms up to 10 years. Long-term debt will most likely have fixed interest rates that convert into consistent monthly payments and high predictability.
Short-Term Debt Financing
Short-term debt financing usually applies to money needed for the day-to-day operations of the business, such as purchasing inventory, supplies, or paying the wages of employees. Short-term financing is referred to as an operating loan or a short-term loan because scheduled repayment takes place in less than one year. A line of credit is an example of short-term debt financing. Lines of credit are also typically secured by assets (or collateral). Short-term financing is commonly used by businesses that tend to have temporary cash flow issues when sales revenues are insufficient to cover current expenses. Startup businesses are particularly prone to cash flow management problems. Credit cards are a popular source of short-term financing for small businesses. In fact, according to a U.S. National Small Business Association study, 59% of small business owners used credit cards for financing in 2017.
Advantages of Debt Financing
The main advantage of debt financing over equity financing is that the lender does not take an equity position in your business. You retain full ownership and the lender has no control over the running of the business. Debt interest costs are fully tax-deductible as a business expense, and in the case of long-term financing, the repayment period can be extended over many years, reducing the monthly expense. Assuming the loan does not have a variable rate, the interest expense is a known quantity for budgeting and business planning purposes. Other advantages include:
Builds up business creditProvides leverage for owners’ equityGives stability in budgeting and planning for futureLong-term debt can eliminate reliance on more expensive short-term options
Disadvantages of Debt Financing
For extended financing, banks normally require assets of the business to be posted as collateral for the loan. If (as is common with small businesses) the business does not have sufficient collateral, the lender will require personal guarantees from the business owners. According to the Small Business Administration: As an owner, this leaves you personally responsible for paying back the loan, even if your business is incorporated. If your business is unable to make the loan payments, whatever personal assets you posted as collateral—house, car, investment accounts, etc.—can be seized by the bank. With debt financing, the fixed repayment schedule and the high cost of loan repayment can make it difficult for a business to expand. With equity financing, money is invested in the business in exchange for equity. There is no fixed repayment schedule, and investors generally have a long-term goal of return on investment. If your business is in need of debt financing or equity investment, you must have a solid business plan in place before any lender or investor will consider giving you funding. This includes the financial details of your business, such as an income statement, cash flow projections, and a balance sheet.
