Debt financing occurs when an organization raises money for capital expenditures or working capital by selling notes, bills, or bonds. The firm can sell these products to institutional or individual investors. In return for receiving the money through these investment vehicles, each person or group becomes a creditor. It’s a promise to repay the principal and interest on the debt over an expected period.
Most debt financing arrangements involve a timeframe of 5 to 30 years, depending on the products sold. Early-stage companies often see this option as a convertible note so that it becomes easier to raise startup capital. It’s much cheaper to use this approach than to doing a priced round stock. Instead of setting a final valuation, the firm sets a cap value for the note.
That means this process is the opposite of equity financing. When looking at the advantages and disadvantages of debt financing, it is essential to remember that these funds must get paid back.
List of the Advantages of Debt Financing
1. Debt financing allows you to keep control.
It might be tempting for startups to pursue angel investors or venture capitalists when raising money for a business. That method creates a fast infusion of cash to accomplish goals, but it often requires a percentage of equity and a royalty to complete the deal. When an investor has equity, it usually has voting rights which allow it to influence the decision-making. When businesses use debt financing as a way to raise the money needed for new ventures, then it allows the owners to keep ownership of the company and continue calling the shots.
It’s an approach that is similar to borrowing money from a bank. You’ll need to pay the interest back on the products sold, but it gives you an instant infusion of cash without having anyone get involved with the daily operations of the company.
2. You can reach a lower interest rate with debt financing.
There can be tax advantages to taking on debt. It can lower the overall interest rate that you pay when meeting your obligations with this option, helping you to grow your business while having access to the liquidity you need. It can be a calculation that’s difficult to manage in some situations, so you’ll want to speak with your accountant to see if this potential advantage applies in your circumstances.
3. It is easier to plan your payments with debt financing.
When you choose debt financing for your business, then you are going to know well in advance what your monthly, quarterly, or annual payments will be. That means you can comfortably budget for the principal and interest that needs to get paid back every period. If you need to make financial plans for your business to create future opportunities, then the predictability of this cost can be a significant advantage.
4. There are several different ways to approach debt financing.
Organizations have multiple types of debt financing to consider when this approach is deemed to be the best one to take. Loans are one of the most common options, providing a lump-sum of cash to be repaid over a set time. Long-term loans extend the repayment terms over several years, so a low-interest rate can be tremendously advantageous in this situation.
Lines of credit offer more flexibility with a set limit that a business can borrow. When your organization repays the debt, then it has access to more funds to use. It’s particularly useful if you need an emergency fund in your first days.
Business credit cards, accounts receivable financing, invoice factoring, and corporate bonds are also possibilities.
5. Tax deductions are possible with debt financing.
Taxes are a crucial consideration to consider when looking at the advantages and disadvantages of debt financing. Companies can often classify the interest payments and principal as a business expense. That means the government is a partner that works to support your organization with a beneficial tax rate that can help you to grow.
You’ll need to look at your specific situation to see if there are tax benefits to consider for your company. Specific state laws and different international standards may apply in some situations.
6. There is a high degree of availability for lending options.
Debt financing options are available to almost every business in any industry. It doesn’t matter what your size, structure, or credit history happens to be. Although you’ll pay higher interest rates if your lending needs present a significant risk to lenders or investors, this option can be an effective way to get a quick cash infusion for a specific purpose.
Because most companies that look at debt financing are already struggling with cash, this option is often the position of last resort to consider. It can provide numerous opportunities, but this decision comes with significant risks to manage.
7. You can have access to reasonable terms and conditions.
Products like the small business loans offered by the U.S. government provide reasonable terms that are easy to manage. Although not every owner qualifies for these products, you’ll find that they have lower down payments, limited interest rates, and negotiable term lengths. You may even have the option to restructure your agreement if you run into financial difficulties for some reason.
That means you can have a consistent cash flow that is necessary throughout the year. It can help a business invest in new equipment, make payroll, or handle other operational or overhead responsibilities.
List of the Disadvantages of Debt Financing
1. You need to pay back the debt.
When you need to make payments on bonds and other debt financing products, then it can be a stress-free experience when you have plenty of incoming revenues. What happens when sales go down for a company, or if bankruptcy becomes necessary? This debt won’t just disappear if something unexpected happens. It can be a risky option if your business isn’t standing on firm financial ground.
If you get forced into bankruptcy because of a failed business venture, then your lenders have a claim to repayment before any equity investors in the company.
2. It can be expensive.
Debt financing carries with it an interest rate that requires a higher interest rate than what the current market rate is for government securities. That’s why it can be an inviting proposition for some investors, but it also means that you’ll need to offer a competitive interest payment to get the best investors interested in your offering. It is not unusual for corporate bonds and similar debt financing instruments to be 2 to 3 percentage points higher than what more conservative investment options provide.
Your credit history and a variety of additional factors, like the state of the market, will be the eventual determiner of whether this becomes an advantage or disadvantage of debt financing. You may find that after calculating your discounted interest rate after taxes, you’re paying an amount that cuts into your profits a little more than you’d like.
3. Some lenders might put restrictions on how the money can get used.
Some businesses decide that debt financing isn’t their best option because of the imposed restrictions that would be on the funds. An organization might receive the cash that it needs only to discover that the stipulations for spending apply to areas of the firm where this attention doesn’t feel necessary. When you add in the challenging borrowing requirements that may be in place to access this cash in the first place, it may be easier for some startups to look at different equity options instead.
4. Collateral may be necessary for some forms of debt financing.
If your business is in its first days, then some lenders may want your company to provide collateral to secure the desired financing. This collateral might include cash, in addition to hard assets. That means some of your business assets will be at risk if something happens that causes you to miss payments on your debt. Some lenders might ask you or other owners or stakeholders to personally guarantee the loan if you’re a startup, which means you must consider putting your own assets at risk to get the funding you want for your organization.
5. It can create cash flow challenges for some businesses.
Some companies sell the same number of products and services each month. Others have times that are quite busy, and then moments when there is virtually no activity at all. Although you can structure your bonds and other debt financing options to work with your busy season, there’s no guarantee that your income levels are going to be the same season-to-season. Debt financing requires equal installments at an agreed-upon time, which means any late payments or defaults because of cash flow issues could put the viability of your company at risk.
If you are not absolutely certain of your ability to pay back a loan, then your company shouldn’t take on any debt financing options.
6. You may need to meet qualification requirements.
It is usually easier to secure debt financing for businesses than it is to take out a loan using personal credit. That doesn’t mean that a company doesn’t need to meet certain qualification requirements. If you pursue a loan or another traditional lending option, then your credit score may need to be high enough to receive the cash you want. Some lenders may require you to present your business plan to ensure that the risk levels are within an acceptable range.
If you use corporate bonds or a similar vehicle for funding, then your credit rating will have a direct impact on the risk profile that investors are willing to accept. A company with a AAA rating will receive a lot more interest than one with a C rating.
7. Borrowing will impact your credit rating.
When and what you borrow has a direct impact on the credit rating of your business. If you structure the company as a partnership or sole proprietorship, then you’re directly responsible for the debt. That means your business and personal credit rating could be adversely impacted by this decision. Repaying the debt in a timely manner, according to the agreements offered, can raise your profile – but borrowing a large sum of cash without a robust reputation will always translate into higher interest rates. That’s because there is more risk to the investor.
8. Debt financing requires high levels of internal discipline.
You must have the financial discipline to make your payments on time when your business decides to use debt financing. That means it is essential for the agency to use sound financial judgment when using debt. When companies become overly dependent on this mechanism to stay afloat, then it almost always results in an outcome that increases investor risk. This issue could even limit access to equity financing when your organization is ready to take that step in the future.
9. There may be a cash-on-hand requirement to meet.
When companies pursue debt financing, then they must meet the cash requirements of the lender. You can avoid this disadvantage by issuing corporate bonds, but then you may not have a guarantee of funding. When there’s a need to have a sufficient amount of cash available, then it can be challenging for a company dependent on this option to get the cash infusion they needed.
10. You lose the option to add expertise to your business.
When you pursue debt financing over equity options, then you lose the opportunity to add experience to your organization. Angel investors and venture capitalists work with you to grow your company because they have a direct equity stake in a successful outcome. When they help you to succeed, then they’re improving personal profits simultaneously. If you’re getting started in an unfamiliar industry with a great idea, then this disadvantage could limit your future opportunities in the short-term until you can hire expertise internally.
11. It can be difficult to apply for some small business loans.
If you apply for an SBA loan in the United States, then you’ll quickly discover that there’s an extensive amount of paperwork necessary to complete the application. You’ll need to provide cash flow projections and personal finance reports just to qualify for the debt financing product. It also takes a relatively long time to process these documents, and there is no guarantee that you’ll receive the desired outcome.
That means you can end up dealing with a lot of paperwork and time investments without receiving the outcome you want.
12. There could be limits on the amount you’re allowed to issue or borrow.
You may find that there are limits on the amount that you can borrow. Most lenders will look at the total value of your assets, current cash flow, and credit risk to determine an upper limit that they’re willing to offer. This disadvantage may apply even when you put your personal reputation at stake to secure the debt financing that you want. If you approach the SBA for lending products, then anyone with a 20% equity stake or greater inherits some personal risk automatically. That’s why it is imperative to do your research before securing financing options in this way – you don’t want to put your business or personal finances into a danger zone.
If you use debt financing to invest in fixed-cost items like equipment or furniture, then you may never see any direct cash returns for what you borrowed. This option is risky when you consider that your installment payments could begin immediately after taking the money. When you have variable costs for inventory or materials that create sellable goods, then it becomes possible to push your revenues higher.
It can be tempting to get an infusion of cash for a new business to get things moving. This approach can also be dangerous since most companies lose money before they turn a profit. If you can’t make the payments on your bonds, loans, or other products, then it can hurt the business credit rating for a long time.
When looking at the advantages and disadvantages of debt financing, it is essential to remember that the chances for bankruptcy are at their highest during the first few years of operations. If you’re in that stage, then you might want to think twice about your options.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.