What is Debt Financing?

There are several good reasons for why debt financing is a strong option for your business, as it can be a contributor towards the growth of your business, enabling you to take on new and exciting projects.

What exactly is debt financing? 

It is the process of borrowing money in the form of a secured or unsecured loan from a third party for working capital or expenditures. Small businesses use debt as a way to maintain ownership of their business.

However, not all debt is the same. It is important to determine whether a line of credit or a term loan suits your strategic business needs.

A Business Line of Credit:

  • Flexible borrowing, similar to a credit card
  • Pay after use of credit
  • Variable interest rate
  • Best for operational purposes, such as payroll, or routine, inexpensive purchases

Example: You own a roofing company, and have recently completed various jobs across the region. You have a high amount of receivables, but employee payroll is in four days and you don’t have the cash on hand due to the receivables gap. A line of credit can bridge this gap and allow you to complete payroll at a low-interest rate.

A Term Loan:

  • A fixed interest rate for a single loan
  • A lump sum paid out
  • Monthly payments begin immediately
  • Best for financing large capital purchases, major projects, or refinancing debt

Example: You own a successful restaurant that is fully reserved every night. You decide to accommodate the growing demand, by opening a second location on the other side of town – a massive capital investment. You can cover some of the cost, but need long-term debt financing for this project. A term loan would extend as monthly payments at a fixed rate over the course of your expansion. With all term loans, interest rates are fixed and later you may receive a new rate if you apply again based on the lender’s risk assessment.

It is important to note that, with a term loan, you have to consider whether you will seek out a secured (commercial) loan from a bank, or an unsecured loan. Commercial bank loans have low interest rates, but are very selective in approval rates and take a long time to process. Unsecured loans have higher interest rates, but fast access to capital. Companies such as Lending Loop bridge the gap by providing fair interest rates and fast access to capital.

When is Debt Financing Right to Grow Your Business?

Debt has historically had a bad reputation among firms due to industry horror stories of excessively high-interest payments, and unfavorable treatment by creditors.

However, debt can be one of the greatest tools a small-medium size business can utilize to compete with larger businesses, expand operations, take on a new project, or improve credit rating. Debt can give businesses the ability to pursue aggressive growth strategies, or add additional working capital for your business needs. Not all debt is the same, and it is important to determine if a creditor is a right fit for your business.

For small businesses, you have to conduct a cost-benefit analysis to determine if receiving a loan is something that would provide additional value to your operations. For many growing businesses, they are expanding at such a fast pace that they require additional capital beyond self-financing to sustain their growth.

Benefits of Debt Financing

  • Fast access to various amounts of capital beyond your current cash balance
  • Retain ownership of your company, in contrast to equity financing such as venture capital
  • The interest payment is a deductible business expense and therefore minimizes tax liability
  • Builds credibility and a record of creditworthiness to lenders

Drawbacks of Debt Financing

  • Interest payments, and unfavorable APRs
  • Process of securing a loan, including gaining approval due to credit
  • Increased risk of bankruptcy

Traditionally, these drawbacks have been emphasized in the debt market with commercial banks being extremely slow and selective in the loan approval process, and unsecured online lenders charging extremely high-interest rates that interfere with monthly cash flows and increase the risk of business failure.

Want to know if you qualify for a small business loan? Check your eligibility here.