Business owners, especially small firms, may need to obtain funds from external sources to keep a business running. External financing includes selling a company’s shares to investors or taking a debt. This way, a firm keeps operating, and business owners can reach their goals. However, there are advantages and disadvantages of debt financing.
- 1 What is Debt Financing?
- 1.1 Advantages of Debt Financing
- 1.2 Low Interests on Payments
- 1.3 Boosts Business Credit Score
- 1.4 Accessibility
- 1.5 No Profit Sharing
- 1.6 Disadvantages of Debt Financing
- 1.7 Lower Cash Flow
- 1.8 May Affect Credit Rating
- 1.9 Repayment
- 1.10 Collateral
- 1.11 Are There Alternatives to Debt Financing?
- 1.12 Final thoughts
What is Debt Financing?
Debt financing is the process by which small or startup businesses borrow money from external sources for business operations. However, there are terms and conditions for loan repayment, depending on the amount and the source. These sources could be banks or government sources that give short-term loans.
Advantages of Debt Financing
There are several pros of debt financing, including:
Low Interests on Payments
No matter the amount of money a firm borrows, the payments are tax-deductible. Hence, you’re assured you’ll pay your loan depending on your company’s marginal tax rate. Hence, you incur no losses, especially if the loan helped your business grow. This applies despite the method you used to borrow money, including invoice factoring.
Boosts Business Credit Score
Though debt financing may seem like a hazard to a small company, it helps improve a small firm’s credit score. Hence, if you pay the debt within the agreed period, you increase the possibility of borrowing a higher, long-term loan, which may boost the growth of your small firm to a larger one.
Small businesses have many options to choose from when looking for short-term loans. Hence, debt financing is the quickest way to obtain a loan because of its accessibility. That’s why most small companies, despite their size, choose debt financing instead of equity financing, which is limited.
No Profit Sharing
If you need a loan through debt financing, you can go directly to the creditor. You don’t need an investor to help you through the process. Hence, you enjoy the profits alone after boosting your business to earn profits. Hence, you don’t have to worry about sharing profits with third parties, which can sometimes be a loss.
Disadvantages of Debt Financing
Despite several advantages, you should consider the disadvantages of debt financing, including:
Lower Cash Flow
Once you take a loan, you may be tempted to take another one after repayment. Hence, you must repay within the agreed time following the terms and conditions. This may lead to low cash flow problems in your firm, which can also affect business growth. It includes cash flowing into the business accounts if you borrowed through invoice factoring.
May Affect Credit Rating
Borrowing once or twice to grow your business and repay loans on time can boost your credit score. However, excessive borrowing and reliance on loans can affect your credit score. Thus, lenders may charge a higher interest rate if you’ve borrowed subsequent loans in the past years.
Despite the amount of money you borrow, you need to repay with interest which also leads to negative or low cash flow. Even if the business fails after borrowing, you need to repay the loan. This could lead to bankruptcy, affect your mental health and may be difficult to start another business in the future.
When borrowing for a small business, you have doubts about loan repayment in the future. Again, lenders require you to give collateral if you can’t repay. Hence, business owners use collateral, such as insurance policies, homes, cash, boat, car, and cash in a savings account. This could lead to losses if the lender ends up with collateral as a form of loan repayment.
Are There Alternatives to Debt Financing?
Depending on the disadvantages of debt financing, you can try other ways to grow your small business. Though they have their advantages and disadvantages, you may prefer them o debt financing. Alternatives of debt financing include:
- Equity financing
- Mezzanine financing
- Credit card financing
Debt financing can be crucial to small businesses, especially if you plan wisely to boost your company. Whether you borrow from lenders using invoice factoring or collateral, you should consider the advantages and disadvantages of debt financing. Again, you can try other alternatives to debt financing if you find them with more straightforward terms and conditions.