Debt Financing for Small Business Owners: Pros and Cons

When business owners require funds to run their operations on a day-to-day basis or to make major acquisitions, they may need to seek outside funding. If internal finance sources, such as the business owner's personal funds or cash from family and friends, are unavailable, external financing may be required.

Taking on debt to support operations or selling shares of your company to investors are the two primary forms of external financing for business operations. Both sources of funding have benefits and drawbacks, and which one you choose is determined by your business goals.

Before you consider the advantages and disadvantages of debt financing, which may vary based on the type of debt you employ to run your business, you should first understand what it is.

What Is Debt Financing and How Does It Work?

Debt finance for a small business is the practice of borrowing money from a third party in order to keep the business running. According to the terms of the loan, the business owner is liable for repaying the principal amount plus a percentage charge of interest. 1 When a loan is taken out, a repayment schedule for the principal and interest is usually created.

When you think about debt finance, you would imagine borrowing money from a bank in order to acquire a bank loan. However, depending on the demands of the firm and its ability to repay the loan, there are a variety of additional debt financing options. Depending on the riskiness of the firm and its stage in the life cycle, each has advantages and disadvantages.

Debt financing can be either short-term (with a maturity of less than a year) or long-term (with a maturity of more than a year). Debt can be secured (supported by collateral) or unsecured (not backed by collateral). Owners of very small, local businesses can finance their operations with accounts payable, often known as trade credit, or even their own credit cards. 2 The Small Business Administration, for example, is a government supplier of business loans (SBA). Larger companies, on the other hand, have a variety of debt funding alternatives, ranging from bond issues to venture finance.

Equity vs. Debt Financing

The reason a company takes on debt or equity financing is because it requires funds to stay afloat or expand. Debt financing is the practice of borrowing money and using the proceeds to keep operations running or expand. External equity financing, on the other hand, is the process of selling a share of your company to outside investors. Internal equity financing happens when the owner contributes personal funds to the company, as well as contributions from family and friends.

Many businesses utilise a combination of loan and equity funding. In the early stages of their existence, many startups are required to use some form of equity financing. Debt financing becomes a more realistic, and probably preferable, method as a corporation develops a financial track record that can be documented by financial statements.

When Should Debt Financing Be Used?

There are various situations where debt financing is better to equity funding:

High-Growth Companies

Debt finance, rather than equity financing, may be a better option for fast-growing businesses. Fast-growing businesses require increasing quantities of capital. Because interest payments made on debt are tax deductible, debt financing is less expensive than equity financing. In order for debt financing to be successful, the company must be able to generate enough cash flow to cover the debt financing's interest payments.

Needs for Short-Term Funding

Another instance where debt should be used instead of equity is when a company need short-term funding. Short-term debt financing is used to fund a company's working capital needs, such as accounts receivable and inventory, and typically has a one-year maturity.

Management Control

Debt financing does not require the firm owner or manager to relinquish any control or ownership interests.

The Benefits and Drawbacks of Debt Financing

Pros

• Interest payments are tax deductible.
• Control by the management
• Interest rate reduction
• Accessibility
• Credit score for a company
• There will be no profit sharing.

Cons

• Repayment
• Flow of funds
• Collateral
• Credit Score

The Benefits of Debt Financing

Interest Payments Are Tax Deductible

Interest payments on debt financing are considered an expense and are therefore tax deductible. This is one of the characteristics of debt finance that makes it more appealing than equity financing. If your business's marginal tax rate is 30%, for example, the amount of interest payments protects that portion of your revenue.

Management Oversight

When you borrow money from a bank or another lender, you become obligated to make the agreed-upon instalments on schedule, but that's it. Without outside intervention from private investors, you retain the liberty to manage your firm as you see fit.

Interest Rates are Lower

The cost of equity financing can be higher than the cost of debt financing. Because interest payments are tax deductible, the interest rate on a bank loan or other kinds of debt financing will be lower than the cost of equity. 3

Accessibility

Small businesses can get debt financing more easily than they can get equity investment. For example, just 0.07 percent of small enterprises ever seek equity investment from venture capital firms. The majority of small enterprises are significantly reliant on debt finance. Debt finance comes in numerous forms, from bank loans to merchant cash advances. Debt financing isn't a one-size-fits-all solution.

Credit Score for a Company

Debt finance may appear to be bad to organisations since no one enjoys being in debt. Businesses can increase their business credit score by demonstrating creditworthiness in debt management, such as making on-time payments.

There will be no profit sharing.

There is no profit sharing if the company uses debt financing because there are no investors. Profits are not required to be shared with creditors by businesses. The profit can be kept by the business owner and distributed as needed.

The Drawbacks of Debt Financing

Repayment

If a company employs debt financing to borrow money, it must pay it back. Regardless of their cash flow status, they must repay debt and interest. Even if the company goes out of business, the obligation must be paid. If you're driven into bankruptcy, your lenders will have a claim for repayment before any equity investors.

Flow of Cash

A business's cash flow will be harmed if it relies too much on debt financing because principal and interest payments must be made on the debt. A company's debt-to-equity ratio can be used to assess its reliance on debt funding vs equity financing. It's preferable if the ratio is as low as possible. 5 One of the most common difficulties that small businesses encounter is a lack of or negative cash flow.

Collateral

In order to obtain debt financing, many small firms may be required to put up collateral. Many business owners are wary of collateral since it sometimes requires them to use assets that they own privately, such as their homes.

Credit Score

When your company needs money, it may seem appealing to keep taking on debt—a technique known as "leveraging up"—but each loan will be shown on your credit report and will have an impact on your credit rating. Because the lender's risk increases when you borrow more, you'll pay a greater interest rate on each succeeding loan.

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