What Is Debt Financing?

What Is Debt Financing? article image.

When you need money to operate or grow your business, debt financing can help. Debt financing—which includes business loans, lines of credit, credit cards and even loans from friends and family—can provide the resources you need for both short-term expenses and long-term investments without sacrificing your equity stake in the business.

How Does Debt Financing Work?

Debt financing simply means borrowing money for the benefit of your business. You agree to repay the money with interest, just as you would with a personal or home loan. Although you may be able to finance some business expenses with your existing credit cards or loans from friends and family, most often debt financing means taking out a business loan.

Learning how to get a business loan takes a bit of homework and preparation. If you're ready to dive in, these three steps can get you started:

  1. Make a business plan. You need to convey the viability of your business—and your future prospects—to lenders with a formalized business plan. You also need to quantify how much money you need and for what. A business plan helps you clarify your needs, your goals and your route to profitability.
  2. Consider different types of loans. Business loans take many different forms. Common types include:
    • Bank loans
    • U.S. Small Business Administration (SBA) loans
    • Business lines of credit
    • Equipment loans
    • Invoice financing or accounts receivable financing
    • Merchant cash advances
  3. Mind your credit. As with any type of loan or credit, loans to help finance your business rely on your credit score and credit report to determine your creditworthiness—and the interest rate and terms you'll get. If you have an established business, you may have built business credit over the years. If not, your personal credit score and report may help bolster your case for getting a loan. Be aware that if you do use a personal guarantee to secure a business loan, your personal credit—along with any personal assets you use as collateral—may be at stake if you have trouble repaying your debt.

Pros and Cons of Debt Financing

Debt financing has both positives and negatives for businesses in need of a cash infusion. Among the reasons to consider taking on debt to build your business:

  • You retain control. Compared with equity financing—which involves selling off a partial stake in your company to investors—debt financing allows you to retain control of your business. Your lender has no say in how you run your operations, and once your loan is paid back, your relationship with the lender is over.
  • Interest rates may be favorable now. Although interest rates fluctuate and every loan situation is different, interest rates are low at the time of this writing. Your chances of getting a loan at a favorable rate in this environment are relatively good.
  • Interest on business debt may be tax deductible, though principal payments toward your debt are not. Business debt includes any business loans or lines of credit, business credit cards, and mortgage or vehicle loans used for property and cars used in your business.

On the downside, debt payments can put a drag on your cash flow. You'll need to keep up with your payments, regardless of how your business is doing. Before you take on any business debt, make sure you have a clear idea of how you'll use the cash for your business and how you'll pay the loan back over time.

When Is Debt Financing a Good Idea?

Using borrowed funds to build a business works better for some business owners than for others. Debt financing might be a better idea for you if you fit the following:

You know exactly how the money will help. The more definite you are about the scope and purpose of your proposed funds, the better. Flexing your credit to onboard additional staff so your accounting business can meet the tax-day rush? That's a defined use of funds with an identifiable payoff. On the other hand, borrowing money to cover expenses month after month—with no clear end or remedy in sight—is a bigger risk, both for you and a lender. To help ensure that you're not throwing good money after bad, take the time to delineate in as much detail as possible what you'll use the money for and how that investment will pay off.

Your business is already established. It's certainly possible to get a loan to start a business. But you'll have an easier time—and more funding choices—if your business has a history. Your track record also makes taking on debt less risky for you. Revenue, expenses and operational needs are more concrete—and quantifiable—when your business is already up and running.

You have good credit or a viable source of funding. Whether you've established business credit or hope to rely on your personal credit to secure a loan, good credit is a key asset for business borrowers. Again, this is a good time to check your business credit (if you've established it) and your personal credit score and credit report to help you assess your lending options. It's also a good idea to take stock of your available credit—and to investigate what your options might be for adding a line of credit or credit card to the business accounts at your bank.

Debt Financing Alternatives

If you're interested in debt financing, you have a wealth of options to consider. The SBA offers loan guarantees that can help small business owners secure business loans with favorable rates and terms. Online lenders offer an alternative to banks, which can be conservative when it comes to business lending.

Are you in need of emergency financing—or are you unsure of your ability to get a business loan? You might consider using credit cards to cover minor short-term gaps in funding: Just be wary of high interest rates that can make credit card debt more difficult to pay off. This plan works best when you have a clear plan for paying off your balance quickly. You might also look to friends and family for help, or even think about tapping your own home equity. Before you take this kind of leap, however, think through your ability to repay. Depleting your personal assets or failing to repay your loved ones can do lasting damage that goes well beyond business.

Alternatively, consider other ways to finance your business. If you're open to equity financing, an angel investor may be able to provide financial backing and—in ideal circumstances—play an advisory role as you grow. You may be eligible for grants from the SBA, community agencies or nonprofits in your area. Crowdfunding sites like Kickstarter or GoFundMe may also help you raise a bit of capital to launch a new product or keep the doors open through a rough patch.

Using Debt Wisely

The wise use of debt can help you overcome obstacles or seize opportunities at critical points in the life of your business. The key is knowing when and how to activate debt financing to fuel your success. By sizing up your business and personal credit status, evaluating your objectives and prospects, and actively exploring all funding options, you can help your business develop greater flexibility—in both good times and bad.