Debt Financing Pros and Cons
If you’re a small business owner, it’s quite likely you’ll eventually run into the need for some additional cash to purchase inventory, hire help, or buy that piece of equipment that will streamline your processes. In most cases, debt financing is the solution.
What is Debt Financing?
Simply put, debt financing is the technical term for borrowing money from an outside source with the promise to return the principal plus the agreed-upon percentage of interest. Most people think of a bank when they think of this type of borrowing, but there are actually many types of debt financing that are available to small business owners. These can include micro loans, business loans, credit cards, and peer-to-peer loans.
Of course, there are many debt financing pros and cons that need to be considered before taking any funds from an outside source. These need to be weighed carefully, and it’s always important to remember that what is good for one business owner may not be such a good idea for another.
Let’s start with the pros of debt financing. Yes, although debt in itself has a somewhat negative connotation, it can also be a healthy aspect of your business’s balance sheet. Let’s take a closer look at these advantages.
The Pros of Debt Financing
- Maintain Ownership of Your Business
You might be tempted to get an angel investor for your growing business. This is definitely a way to infuse cash into it. But, you’ll need to ask yourself if you want outside interference from investors? If you prefer to call the shots for your business, it makes sense to leverage debt financing – in other words, borrowing from a bank or other type of lender and paying it back in the agreed upon timeframe. The bank may charge you interest on what you borrow, but they’re not going to get involved with how you run your day-to-day operations.
- Tax Deductions
Surprising to some, taxes are often a key consideration when pondering whether or not to use debt financing for your business. Why? In many cases, the principal and the interest payments on business loans are classified as business expenses. These can be deducted from your business income taxes. In some ways, the government is your partner in your business with a percentage ownership stake (your tax rate).
- Lower Interest Rates
This is a somewhat difficult advantage of debt financing to understand, but it can actually be quite valuable. Tax deductions can affect your overall tax rate. In many cases, there can be a tax advantage to taking on debt. For example, if your bank is charging you 10 percent interest on a business loan, and the government taxes you at a 30 percent tax rate, you can tabulate the following Take 10 percent and multiply it by (1-30 percent), which equals 7 percent. After your tax deductions, you will pay a 7 percent interest rate instead of a 10 percent rate. It’s a win-win financial move that lets you both get the money you need to grow your business while also helping to slash your tax rate.
The Cons of Debt Financing
- Paying Back the Debt
Making payments to a bank or other lender can be stress-free if you have ample revenue flowing into your business. But, what if sales are down? Or, worse yet, what if your business should fail? You’ll still be on the hook for the debt. Business debt financing can be a risky option if your business isn’t completely on terra firma. To add insult to injury, if you are forced into bankruptcy due to a failed business, your lenders will have claim to repayment before any equity investors in your business.
- High Interest Rates
Your parents may be willing to loan you some cash at a next to nothing interest rate, but don’t expect this from a traditional bank or other lender. Interest rates certainly vary on a variety of factors including your credit history and the type of loan you’re trying to obtain. However, even after calculating the discounted interest rate from your tax deductions, you may still be paying a high interest rate each month that cuts into your profits.
- The Effect on Your Credit Rating
What you borrow does affect your credit rating. And, this effect can be negative if you’re borrowing large sums. This translates into higher interest rates and more risk on the part of lenders.
- Cash Flow Difficulties
Not all businesses sell the same amount each month. In fact, most have periods of time that are busier than others. However, lenders typically expect payment on any debt financing in equal monthly installments. This can be a real challenge that can lead to late payments or even defaults that can harm your credit over the long term. If you are not absolutely certain that you can pay back the loan, it’s not a good idea to get one!
When Should You Use Debt Financing to Fund Your Business?
As Kenny Rogers sang in the song “The Gambler,” you need to know when to hold them and know when to fold them. And, this definitely applies to debt financing. It’s not for every business owner, and understanding when to leverage the advantages of debt financing can literally make or break your business. To determine whether it’s the right business move, there are a few important questions to ask yourself:
- Will I use the funds to invest in variable or fixed costs?
When you invest in fixed costs such as office furniture or a piece of equipment, you probably won’t see direct cash returns from the funds you’ve borrowed. This can be a risky option for debt financing when you consider that your installment payments on the loan will begin soon after the money is lent. However, if the money will be used for variable costs such as for inventory or materials to make products you sell, the investment can result in immediate increased cash inflow.
- At what stage is my business in?
When you’re just launching a venture, it can be tempting to want to get an infusion of cash to get things up and rolling. However, debt financing in the early stages of a business can be quite dangerous. Almost all businesses lose money before they start turning a profit. And, if you can’t make payments on a loan, it can hurt your business credit rating for the long-term. As your business begins to flourish, and you have a better understanding of how much you’re truly making, debt financing becomes a more logical option. Remember – the chance of bankruptcy is highest during the first few years of a business and then it decreases the longer you’re operating.
- Do my customers pay on time?
If you’re reliant on your customers to pay you on time so that you can pay your loan, you better make sure that those who buy from you are very reliable. Too often, this isn’t the case. Pay close attention to the payment habits of your customers. It may make sense to offer financial incentives to get them to pay early. Not sure if you’re offering the right terms for your customers? Ask others in your industry such as within trade organizations or even competitors. You may be able to ask for more up front or for quicker payment depending on what the typical payment requirements are within your industry.
- Am I organized enough to make regular payments?
Let’s face it! Not every business owner is a financial genius. That doesn’t necessarily mean you shouldn’t have your own business, but it might indicate that using debt financing could lead to trouble – especially if you have a habit of forgetting to make payments. If this sounds a bit like your modus operandi, it may be worth exploring other types of financing which we’ll get into next.
When Debt Financing Isn’t the Right Choice
Whether you have bad credit, don’t want to deal with the hassles of paying back a loan, or just aren’t at the right point in your business’s lifecycle to take on debt, you do have other options that might be worth exploring if you need cash.
Grants are one option that provides you with money that you don’t have to repay. There are many grant opportunities out there for small businesses. They are often disbursed by government departments, foundations, non-profit organizations, trusts, educational institutions, and sometimes individuals. The Small Business Administration can help you with both looking for grant opportunities and with applying for grants. Online searches can also be quite beneficial – particularly when trying to find private grants such as those that are offered by corporations and non-profits.
It’s important to note that there is a lot of competition out there for this alternative to debt financing, and the timeframe for obtaining grants can be very long. But, it’s definitely an option, and one that can jumpstart your business without putting you into debt.
Do you have a business idea that excites those you share it with? If so, angel investment might be right for you. With a good business plan in hand and a little chutzpah, you may be able to get the funds you need by pitching your idea to the right people. Where do you find them? Start with industry mixers and events to rub elbows with those in the know. From there, you can start building connections and opportunities to share your business plan. While it can be very exciting to get an investor who believes in what you’re doing, it’s also important to remember that they just might want to contribute more than just money to your venture. Some angel investors want to actively participate in the decision making, and yes, they expect a payout at the end of the day from what they invest into your business. There are definitely strings attached when it comes to angel investment. So, if you only want to go it alone, you may be better off steering clear of this financing option.
Family and Friends
Financial gifts and loans from family have helped launch countless small businesses. In fact, they have contributed to the success of some of the most notable companies in the world including Microsoft, Virgin, Disney, and Ford. But like with angel investment, you can expect that there will be strings attached if you choose to take money from loved ones. Having a good agreement written up and a clear understanding of how the loan will be paid back can go a long way towards avoiding problems down the road.
There are those times when traditional forms of debt financing such as bank loans are just not going to cut it because of the time involved with obtaining the funds. For example, you need to hire help to enable you to complete an unexpected and large project. A supplier has given you a deal on inventory that you know you can quickly sell to turn a fast profit. Or, you have a unique marketing opportunity that will enable you to quickly grow your business. Whatever the reason, a business loan might be the right form of debt financing for you. Kabbage is one option that many small businesses leverage to help them.
Kabbage offers a free sign up, and there’s not an obligation to take the money. A Kabbage business loan can be made in minutes, too! This is a good debt financing solution to keep in your back pocket when you need funds fast. And, because Kabbage is not a bank, they do not simply review your credit report to determine whether you should get funds. Instead, they look at a variety of data sources including eBay, UPS, PayPal, shipping analytics, social media numbers, and more. This makes it a particularly good option for a small business that is successful, in need of funds, but may have less than perfect credit.
The good news is that there are a variety of options for small business funding whether you want to go the route of debt financing or with an alternative form of financing. By choosing the right one for your business, you can help secure your present and pave the way for your future growth.