Debt financing and how it compares to other forms of funding
What is debt financing?
Debt financing is any money you borrow and need to pay back. It comes in various forms, including business loans, lines of credit, credit cards, invoice financing and peer-to-peer loans.
How does debt financing work?
Debt financing works like a mortgage, credit card or personal loan. Your business applies for a loan from a bank or other lender, gets the money, usually a lump sum, and pays it back within a set time. Like a mortgage or other loan, your business will generally pay interest on a business loan, along with fines or penalty fees for missed or late repayments. Finance, especially equipment finance, can also be used for capital expenditure (CapEx), which is purchasing, maintaining, or upgrading tangible assets.
Examples of what debt financing looks like
Debt financing comes in various forms, from standard loans to credit cards and peer-to-peer borrowing. Here's a look at some of the main types of business borrowing:
You repay a term loan with regular payments over a set time, like a personal mortgage. Term loans can be short-term, medium-term or long-term — from a few months to ten years or more. You'll pay interest on a term loan, often at a variable rate rather than a fixed rate. If your business has suitable collateral, your term loan may be secured against it but many term loans are unsecured.
Lines of credit
A business line of credit, sometimes called revolving credit, is a flexible borrowing option. Instead of a lump sum, your business gets access to funding up to a set limit. You use your funds as needed and only pay interest on the amount used — not the total.
Invoice financing is a form of short-term lending that lets you borrow cash against your unpaid invoices. You take out a loan to cover the gap between invoicing customers and their payments. This can help you meet your cash flow needs without taking out larger loans.
Business credit cards
A business credit card lets you spend up to a set monthly limit. Much like a personal credit card, it needs to be paid back by the end of the month to avoid penalty fees and interest payable on the overdue amount.
Personal loans from a family member or friend are a way to borrow outside of traditional lenders. Because private lenders can negotiate the terms of the loan without the regulated lending requirements, this type of loan could be the only option for some small business owners in the early days.
Peer-to-peer lending (P2P)
Peer-to-peer lending lets your business borrow from individuals without dealing with finance companies or banks. You sign up to an online P2P platform as a borrower or investor, and the platform sets interest rates, terms and fees, which are often lower than traditional forms of lending.
Depending on the size of your business, you may be eligible for a small business loan from the government or another funding entity. In New Zealand, EECA co-funding provides loans to help businesses lower emissions and other support can be accessed at business.govt.nz. Australian businesses can take out loans to help train their apprentices, and find other support at business.gov.au.
Advantages of debt financing
The main advantage of debt financing is the ability to fuel business growth, while keeping your equity and control over your business.
Debt financing can fuel business growth
Debt financing can be an effective way to fuel business growth. By borrowing to buy equipment or tools, open a new location or upsize operations, you can increase capacity and boost performance in the long term. If that growth pays off in profitability, you repay your loans and continue to reap the benefits without losing control of your business.
Lower interest rates (low cost to borrow)
With so many loan structures, lenders and borrowing options available, you can shop around for the lowest interest rates. You may find that loans through government schemes and long-term secured loans have the lowest rates.
No need to give up equity in your business
Unlike equity finance, which involves handing over shares or partial ownership or control of your business, debt financing lets you retain complete control without giving up equity.
Disadvantages of debt financing
The main disadvantages of debt financing are difficulty qualifying for a loan, repaying with interest and having to secure the loan with collateral.
Business loans can be hard to get, especially with a bad credit rating
It’s not always easy to get a business loan, particularly if you’ve got a bad credit rating or have just started your business. A low credit rating or credit score shows that you or your company have a history of defaulting on loans or payments or that you haven’t built up a history of regular payments. While this may not disqualify you from getting a loan, it could mean working with a non-bank (‘sub-prime’) lender and taking on a higher interest rate.
The money you borrow must be repaid, even if your business goes under
When you take on any loan, you must pay it back — even if your business is struggling or goes under before the loan term ends. This means that taking on debt can be a risk, particularly for small businesses struggling with cash flow and profitability. As the owner, you may have personal liability for debt even after the business is closed.
You may need collateral
Collateral is a physical asset used as security, giving the bank or lender something to liquidate if you can’t repay your loan. With business loans, the collateral is usually the item the loan pays for — for example, a vehicle or machinery. If you stop making repayments, the lender will seize and sell the item to get the money back. If you’re not borrowing to buy tangible assets, you may need something else as collateral — your home, outstanding invoices or commercial real estate, for example.
Debt financing vs equity financing
Debt financing involves taking out a loan that you'll repay. With equity financing, an investor funds your business in return for part ownership.
Key differences between debt and equity financing
The key differences between debt and equity financing are:
Debt financing needs to be repaid, while equity doesn’t.
Equity involves giving up a portion of your business.
Equity funding can be more difficult for smaller companies to secure.
Is debt financing better than equity financing?
Debt financing isn't necessarily better than equity financing — it's different and you may access both for different business needs. Each finance option has pros and cons, and it's about choosing the option that suits the stage of your business, your situation and your tolerance for risk.
Debt financing vs venture capital
Debt financing and venture capital are quite different. Venture capital is a specific type of equity finance, usually for start-ups in a rapid growth phase.
Unlike debt financing, accessible to most business owners, venture capital is only available to a small subset of start-ups that appeal to venture capitalists. Venture capital investment firms look for businesses with innovative ideas and plenty of growth potential. They look for opportunities where they can add value and secure a strong return on investment. Venture capitalists make money when they exit their investment — for example, when you list your business or sell it at a higher value than when they bought their shares.
Debt financing vs lease financing
Lease financing is a way of getting the equipment or vehicles you need without buying upfront. You lease through a lender, who still legally owns the asset, and you make regular payments. At the end of the lease agreement, you generally have the option to extend, return the asset, or buy it outright.
Lease financing is similar to debt financing in that the lender can reclaim the asset if repayments stop. However, lease financing is specific to a piece of equipment or vehicle, while you can use loans to pay for any capital expenditure. Lease financing also tends to have set fees instead of interest rates, which can make budgeting simpler.
Debt financing FAQs
Is debt financing an expense?
You generally don’t classify debt repayments as a business expense for tax purposes. However, you can claim the interest you pay.
Is debt financing the same as a loan?
Yes. Debt financing is a kind of loan.
What are the three main terms associated with debt financing?
The three main terms for debt financing are short-term (generally under two years), medium-term (2-5 years) and long-term (5 years+).
What are the main sources of debt financing?
The main sources of debt financing are loans — business, P2P, personal or government-backed. Other common sources are lines of credit (revolving credit), leasing and business credit cards.
Simplify finance with MYOB
Debt financing, equity, venture capital or leasing — when starting a business, it can be difficult to find the best way to fund your expenses and drive growth.
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