Debt Financing: Using Leverage to Grow Your Business and Reach Your Objectives
Debt financing is one of the most straight-forward and common financing options for businesses today. In this guide, we’ll cover everything you need to know so you can proceed with confidence and find a financing arrangement perfect for your needs.
Let’s get started…
What is Debt Financing?
Debt financing is when a business raises money through a bank or private lender with a promise to repay the principal and interest. At its most basic level, debt financing is a loan.
Terms vary based on your needs. In most cases, interest accrues regularly and you must make payments at regular intervals agreed upon at the time you take out the loan. This makes payments and schedules easy to estimate.
Whether you’re looking to cover operating expenses over the next few months or a 5-year option for long-term goals, you’ll find options from both banks and lending groups ready to help.
Examples of Debt Financing
As one of the most popular forms of financing available, debt financing is available through a range of groups, banks and private lenders. In most cases, groups and private lenders specialize in certain types of loans. These loans might also carry specific requirements you won’t find going through a bank or other senior lending source.
A few of the most popular options include:
Small Business Administration (SBA) Loans
While the Small Business Administration is not a lender, they offer a few programs that can improve the chances of approval through other lenders. With the proper qualifications, they’ll even guarantee all or part of the loan on your behalf.
They offer three major programs:
- 7(a) loans: These loans feature open-ended terms and easier qualifications than their other programs. These loans offer access to up to $5-million in funding. Uses include establishing working capital, covering startup costs, refinancing debt and purchasing real estate and equipment.
- Microloans: Many lenders set lower limits that won’t work with the needs of solopreneurs or basic small business needs. The microloan program helps to cover these smaller debt financing needs with loans ranging between $500 and $50,000.
- CDC/504 loans: While these loans are the most regulated and feature some of the strictest requirements among SBA loan programs, they offer access to up to $5-million in funding based on current treasury rates and terms up to 20 years. Common uses for CDC/504 loans include large equipment purchases, real estate purchases, land improvements and renovation of existing structures.
Merchant Cash Advances (MCAs)
Instead of making a fixed monthly or quarterly payment toward the balance of your financing agreement, MCAs are paid back through automatic deductions from your daily credit or debit card sales. This makes them a flexible solution for businesses with seasonal fluctuations in sales that might struggle with regular fixed payments.
As a niche solution for businesses looking to recover cash flows due to delayed invoice payments, invoice financing (also known as accounts receivables financing) is like a cash advance for unpaid invoices.
Most lenders offer around 80% of the value of your pending invoices. Once invoices are repaid, you’ll receive an additional portion of the remaining amount.
These are probably the first type of loan you think about when you consider debt financing. They work as any traditional loan would. You borrow a fixed amount with a set interest rate. You then pay the balance back through regular payments.
If you’re looking for a predictable payment model and easy to understand terms, term loans are a top pick.
Business Lines of Credit
Offering the flexibility of a personal credit card, a business line of credit provides a pool of capital from which you can draw to cover business needs.
Common uses include handling seasonal cash flows, obtaining working capital and paying off other debts.
Secured by the item you’re planning to purchase, equipment loans are an excellent way to buy computers, vehicles, machinery and other business-related equipment. Since you’ll use the item you plan to purchase as collateral, most equipment financing offers require little to no added collateral for approval.
As you can see, the range of debt financing solutions available to businesses can cover virtually any need.
But how do you know what you’ll qualify for and what type of financing to use?
We’ll cover that next!
What Do Lenders Look for in Debt Financing Agreements?
Since most debt financing agreements require regular payments, lenders will want to be sure that your business can handle the debt and that repayment chances are high. This means you must have documentation ready to answer questions lenders might have.
In most cases, lenders will want to know information including but not limited to:
- Your annual revenue
- Time in business
- Average bank balances
- Overall financial situation
- Existing debts
- Personal credit scores of any borrowers
Exact requirements will vary by lender and debt financing type, so be sure to have information lined up before you apply to ensure a quick application process.
Advantages of Debt Financing
All business financing arrangements have their trade-offs. Debt financing is no exception. However, it has benefits that make it worth it for many businesses.
Leading reasons to consider debt financing over other financing options include:
- You stay in control of your business: Unlike equity financing, debt financing allows you to keep ownership and avoid having to abide by restrictive lender covenants. Once you’ve repaid your debt in full, your business relationship with the lender ends.
- Tax deductions: Since interest paid on debt financing is tax deductible, you can reduce your net obligation and costs over the life of the loan.
- Simplified budgeting and planning: With a clear idea of how often you must make payments and what the total cost of the loan will be, it’s easier to plan and account for the impact of the loan on your balance sheets.
Disadvantages of Debt Financing
As with any financial solution, there’s downsides to consider. These are major points to consider before agreeing to any form of debt financing.
- Repayment and liability: Even if your business fails, you may still find yourself on the hook for the remaining payments to your lender. Should you need to file bankruptcy, debt lenders have a claim to repayment before equity investors.
- Variable interest rates: While you might have great financials on the business side of the situation, your personal creditworthiness and economic trends will also impact the rates offered from most debt financing lenders. This means that even with ideal standing, you might still face high rates for your loan.
- Impact on Creditworthiness: Debt financing is noted on your credit report and will impact your credit rating. As you borrow more, this can add up and make finding future funding more difficult.
- Immediate Impact on Cash Flows: Unlike financing methods with deferred payments or alternative payment models, most debt financing solutions require payments to start shortly after receiving funds. You must ensure that cash flows can handle the immediate impact of the loan and that you’ll be able to continue with business operations while repaying the loan promptly.
Alternatives to Debt Financing
Most experts recommend diversifying financing types. Debt financing is just one category of business funding available.
Other options include:
- Equity financing: With equity financing, you sell shares of your company to investors or inject some of your own funding into the company.
- Mezzanine financing: Using preferred stock options and equity stakes in place of assets as collateral, mezzanine financing offers a flexible solution to bridge the gap between senior lenders and equity financing. While it typically features higher rates than debt financing, its unique structure makes it popular with entrepreneurs and business owners.
- Hybrid financing: As mentioned above, the ideal financial solution for most business is a mixture of both debt and equity financing. In these cases, an experienced broker familiar with structured financing is your best option for finding where the sweet spot lies between financing costs and reaching your objectives.
Where to Find Debt Financing
There’s a good chance that your local bank offers a variety of business financing options. If you’ve worked with them in the past and are in good financial standing, they can likely help you to fund your next project or achieve your business goals.
However, private lenders and financial groups also offer a range of debt financing solutions you won’t find at major banks. An experienced broker can not only recommend reputable lenders likely to work with you, but also help to outline options that fit your current financial situation and plans.
UT Financial Services helps businesses find financial solutions using more than 20 years of experience and extensive connections with private investors and lenders across the country. We specialize in tailoring solutions to the needs of your business and strive to create value for every client we assist.
If you’d like to explore your options, call us or use the form below to send your contact information to one of our analysts. We’ll schedule a time to collect more information about your needs, goals and current situation and start the process of finding a solution customized for your business.
This website and blog is a publication of UT Financial Services, LLC. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed.
Purpose of this blog is to give general education and information about investing and business financing. Information on this website and blog do not involve the rendering of personalized investment advice. No content should not be construed as legal or financial advice.
Consult a professional advisor before implementing any of the options presented.