How does debt financing work?

Many small businesses couldn’t exist without it

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Debt financing is an all-encompassing term referring to a business raising capital through borrowing. The borrowing can come from loans, investors, bonds or other institutions, but the expectation is that the business will pay the funds back with interest and within a defined period of time.

Debt financing offers many benefits for a company, including maintaining control of your business. However, it can come with a few downsides, too, if a business defaults on the loan. We’ll take a closer look at the most common forms of debt financing and the impact it can have on a small business.


Key insights

Debt financing is when a company raises capital through borrowing and must pay back the funds with interest in a set amount of time.

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There are a number of debt financing options, including term loans, lines of credit and equipment financing loans.

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Debt financing allows you to maintain full ownership of the company, but it comes with risks if you can’t make the required payments.

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What is debt financing?

Debt financing occurs when a business raises capital through the borrowing of funds. This money can be used for working capital, real estate purchases, equipment needs or a variety of other business-related uses. Debt financing can be short-term or long-term, depending on the needs and financial situation of the company. It may require collateral or be unsecured.

Debt financing can occur as an installment loan, revolving loan or cash flow loan:

  • An installment loan refers to a traditional loan where the company receives a lump sum upfront and then repays it in installments (typically monthly).
  • A revolving loan means the business has access to open credit it can borrow against as needed, such as a credit line.
  • A cash flow loan is when the business borrows funds based on projected revenue, such as future invoices, instead of traditional collateral.

» MORE: What is debt settlement?

How debt financing works

Debt financing involves borrowing funds from creditors, such as banks, credit unions or other financial institutions, with the promise of repaying the principal amount plus interest within a specified period. Here's how it typically works once a business decides to raise capital through borrowing:

  • Agreement: The business and lender come to an agreement by negotiating terms, which include the loan amount, interest rate, disbursement of funds, repayment schedule and if there’s any collateral required.
  • Funding: Once terms are agreed upon, the financial institution transfers the funds in either a lump sum or installment, depending on the agreement.
  • Repayment: The business makes regular payments to the lender, typically consisting of both principal and interest, according to the agreed-upon schedule.
  • Risk: Debt financing provides immediate access to funds and doesn’t require giving away any ownership of the business; however, it does carry risk if you default on the loan. These risks include fees, penalties, legal action or loss of any assets pledged as collateral.

Examples of debt financing

Debt financing comes in numerous forms, including loans and bonds, plus short-term or long-term options. Some of the more common forms of business lending include:

Term loan

Business term loans operate similarly to auto loans or mortgages, where you borrow a specific amount and pay it back in installments with interest and within a defined period of time. Term loans can be used for a variety of business functions, such as purchasing inventory or building expansions, and they may either be secured or unsecured.

SBA loan

Small Business Administration (SBA) loans are loans guaranteed by the U.S. government but made available through private lenders. SBA loans have competitive interest rates, flexible repayment terms and a wide range of borrowing limits.

Equipment financing

Equipment financing is a form of an installment loan but specifically for the use of purchasing equipment, machinery, vehicles or technology. The equipment serves as collateral, and the loan terms are based on the life span of the specific equipment.

Line of credit

A business line of credit is an example of a revolving loan and works similarly to a credit card. A business can borrow funds up to the credit limit and pay them back within the defined terms of the line of credit. This flexibility makes it an ideal option for a business with unpredictable cash flow or liquidity challenges.

Business credit card

Like a line of credit, a business credit card allows for borrowing funds as needed and can be a more flexible option for a business with fluctuating cash flow. Plus, there’s no collateral required and it’s possible to not pay any interest if payment is made in full each month.

Invoice factoring or financing

Invoice factoring is an example of a cash flow loan. This type of loan allows a business to get funds against outstanding invoices for immediate funding. An invoice factoring company purchases the invoices at a lower value (typically 80% to 95%) and then takes over the collection activity.

Debt financing vs. equity financing

Debt financing means raising capital through the borrowing of funds from financial institutions or other external sources with the intention of paying the money back over time with interest. The loan becomes a liability on the balance sheet until it’s paid in full, but the company never has to give up any ownership stake in exchange for borrowing.

Equity financing also means raising capital, but the funds come from selling ownership stakes to investors instead of through loans. The business doesn’t have to pay back the funds, but it does have to share the profits and decision making with the stakeholders.

» LEARN: Debt relief programs: pros and cons

Advantages and disadvantages of debt financing

Debt financing offers numerous benefits for a business, but it may not be the perfect fit for every company. No matter what form of debt financing a business takes on, it’s critical to weigh the pros and cons before entering any type of agreement.

Advantages

Advantages of debt financing include:

  • Maintain ownership control: Debt financing allows a business to retain full ownership, since loans do not require giving up ownership stakes.
  • Potential tax advantages: If your business meets certain requirements, then the IRS allows tax deductions for business loan interest payments.
  • Faster funding time: Numerous debt financing options, such as business credit cards or certain term loans, have much faster funding times compared with equity financing. This means a business can act quickly or take advantage of opportunities when they arise.
  • Predictable payments: Most debt financing options offer fixed payments or more predictable repayment terms so your business can budget accordingly.

“When used properly, debt financing can be an extremely useful tool to fuel growth,” Joe Camberato, CEO of National Business Capital, a national fintech lending platform, explained. “One of its biggest advantages is that you don't have to give up equity in your business, so in a sense, this allows you to grow more quickly with that extra capital while retaining ownership.”

When used properly, debt financing can be an extremely useful tool to fuel growth.”
— Joe Camberato, CEO, National Business Capital

Disadvantages

It’s equally important to consider the disadvantages of debt financing, which can include:

  • Can put personal credit at risk: “The biggest disadvantage of debt financing is that now you're obligated to pay back what you borrowed. Most business loans these days come with personal guarantees, so you, as the owner, can be personally liable for the debt,” Camberato said.
  • Burden to your bottom line: Having too many debt repayments can add significant financial strain to a business, especially if you have installment payments you owe but the cash flow isn’t steady.
  • Strict qualifications: Many forms of debt financing require strong personal and business credit scores and may require collateral for qualification.

» MORE: How do debt relief companies work

Could your debt be reduced or forgiven? Take our financial relief quiz.

    FAQ

    Are there any government programs or resources available to assist small businesses with debt financing?

    Yes, your small business may have access to loans, grants, disaster assistance and more. The best place to start researching the government programs available to you is with the Small Business Administration.

    What credit score do I need for a small business loan?

    Every lender has its own specific requirements for qualifying for a business loan. Having a good or excellent credit score will improve your chances of approval, although it’s possible you can find some lenders willing to work with lower credit scores. However, having a lower credit score will mean higher interest rates and fees, which can impact your borrowing power.

    What collateral may be required to secure a business loan?

    The collateral requirement for a business loan often depends on the type of loan it is. It can include real estate properties, vehicles, equipment, inventory or accounts receivable. For example, equipment financing loans require the specific equipment you’re financing as the collateral.

    Bottom line

    A business may find it needs debt financing for a variety of reasons, from expansion projects or purchasing equipment to increasing working capital. By borrowing funds from financial institutions, a business can gain access to capital without giving up any ownership stakes in the company. Debt financing comes in a range of options, which include an array of repayment terms, collateral requirements and funding timelines.


    Article sources

    ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:

    1. CFI, “Debt Financing.” Accessed May 10, 2024.
    2. CFI, “Equity Financing.” Accessed May 10, 2024.
    3. IRS, “Guide to Business Expense Resources.” Accessed May 10, 2024.
    4. U.S. Small Business Administration, “Funding Programs.” Accessed May 10, 2024.
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