How To Understand Debt Financing For Business

By Dan Handle, 22 Jan 15:17

Small Business loans and debt financing is a standard way to raise operating capital for your business.

Think of it as a loan in which a creditor agrees to lend you money in exchange for repayment, with accumulated interest, at a future date. Loans are based on your business's existing assets and your perceived ability to repay the loan over a specified amount of time.

Small business loans and debt financing can either be short-term, with full repayment in less than a year, or long-term, with repayment occurring over more than one year.

Unlike other forms of financing, debt financing allows you to retain full ownership of and equity in your business.

The interest you pay on your loan is tax-deductible, and the financing cost you are charged on top of interest is usually a relatively fixed expense. While many people consider the concept of "debt" as a negative, borrowing money in this fashion allows you to effectively leverage the money and/or assets you have, while allowing the value of your equity to grow more quickly.

Debt financing includes a broad array of loans, including credit cards, asset-based financing, trade credits, personal loans, bank loans and lines of credit.

Trade Credits: the purchase goods from a supplier who helps "finance" your purchase by delaying the date at which monies are due or by allowing you to make installment payments. Trade credits can also be sales on consignment: you pay for goods only if and when they are sold, usually retaining only a percentage of the sale and returning the balance to the supplier.

PROS: Allows you to spread out your payments, with minimal or no down payment or interest charges (usually you have to personally guarantee some of the purchase price, at least for initial inventory).

CONS: You usually wind up paying a higher price. By purchasing on credit, you usually forego cash discounts available for immediate payment.
Lines Of Credit. Credit lines are acquired through banks and allow you to draw upon funds, as needed, for routine operating expenses up to the maximum of your credit line over the period of usually up to one year (generally a shorter period than a loan). Like bank loans, credit lines are available only to businesses that can show profit and are well-established. Like loans, they can be secured or unsecured by assets, even receivables and equipment, as well as your personal credit.
PROS: Can be a great "insurance policy" for a healthy business that can allow you the flexibility needed to handle a cash crunch. Lines of credit can also allow you to make purchases that are too small for a bank loan, to underwrite the cost of goods for orders already received, and to handle temporary cash flow fluctuations. As a source of emergency funding, interest rates on credit lines are generally lower than for credit cards.

CONS: Carries an interest rate that is higher than that for a bank loan, plus the fact that you have to meet the same criteria in order to qualify.

"Procrastination is like a credit card: it's a lot of fun until you get the bill." - Christopher Parker

Credit Cards. Many businesses use credit cards as de facto lines of credit to pay for everything from lunch for employees to office supplies to business travel. If your business is able to qualify for its own credit cards, it's a good idea to get them. You don't have to use them, but you'll have a safety net in case other forms of financing fall through. If you are unable to qualify for a credit card because your business is too young, you may have to use personal credit cards instead.

PROS: Immediate financing for business expenses along with the ability to pull out cash advances. Credit cards are also an effective tool for managing expenses and controlling cash flow (i.e., putting all travel and entertainment expenses on your credit card makes it easy for your accountant come tax time).

CONS: High interest rates and cash advance charges. Prudent business owners rely on credit cards only as a means for covering unexpected, short-term expenses they are able to repay quickly.

Asset-Based Financing. Businesses can also rely on certain kinds of assets as collateral for a loan from a commercial finance company. The most common types include accounts receivable financing and inventory financing.

Accounts Receivable Financing: using your "receivable billings" as collateral. As you are able to collect this income, you use the proceeds to repay the loan. A loan made based on the value of your receivables is generally calculated from between 30-75% (the older the account, the less value).

PROS: Allows you to overcome short-term cash flow problems.

CONS: Failure to repay the loan can result in the financier seizing the pledged accounts receivable, which can dramatically affect your business and damage your relationship with ongoing clients and regular customers.

Inventory Financing: using product inventory as collateral. The key factor is in merchantability of your inventory: how quickly and for how much your inventory can be sold. Average lender discounting usually allows up to 60-80% of the value of your ready-to-go inventory. The most common purpose of raising money through inventory financing is to enable you to purchase "new" inventory.

PROS: Allows you to get over a financial "hump" and/or deal with a cash flow problem.

CONS: Failure to repay the loan can result in your inventory being seized.

Bank Loans. Banks lend money to businesses and individuals that have been in business for more than two years and have a history of profitability. Loans must be paid back within a specified period of time (usually several years). Most often, the borrower makes a fixed fee monthly payment that includes repayment of principal along with interest. Banks usually give loans to help profitable businesses finance operations and/or expansion (not to bail you out). Bank loans come in two types: secured (in which you put up business or personal assets, such as real estate or negotiable bonds, that the bank can seize if you default on repaying the loan); and unsecured (no collateral is pledged as the loan is based on your good credit).

PROS: Can be a very flexible source of capital and may offer the advantage of time-saving conveniences, like being able to transfer funds online or by phone.

CONS: It is unwise to go for a bank loan when there is any chance your cash flow will not be strong enough to make scheduled payments (otherwise known as "debt service").

"Acquaintance: a person whom we know well enough to borrow from, but not well enough to lend to." - Ambrose Bierce

Personal Loans. Otherwise known as "friend and family financing," personal loans are loans secured from someone you know personally. Generally these loans range from several hundred to several thousand dollars.

PROS: A business that is less than two years old (or profitable for less than two years) will usually have better luck getting loans from private sources than from institutional lenders. Personal loans can also be a source for money that is needed quickly and/or for unusual business concepts that would be difficult to sell to more conventional money sources.

CONS: Tax liability, unless you make sure your lender charges enough interest so that the IRS doesn't view the loan as a gift and charge you gift tax (check with an attorney). Also, there's always a good possibility of damaging a close relationship by not spelling out terms of the loan, by failing to repay, or by failing to repay within the time period agreed upon. Because of this, you should give a lot of consideration to this option before jumping in.

Things you might need

How-to Extra Advice

Tags: borrow borrowing debt finance capital