What is debt financing and is it right for your business?

Debt financing can seem intimidating. Many individuals take pride in keeping their personal debt low, often just having a mortgage or a credit card. However, small businesses can’t always rely on monthly income alone. Factors like challenging market conditions, unexpected expenses, inventory costs or slow sales can affect cash flow and operations. When used wisely, debt financing can help your business navigate these tough times, but it’s crucial to fully understand your options.

Key takeaways

Debt financing can be a good way to secure the finance your business needs to grow. Here are three key things it allows you to do:

• Retain control of your business by securing funding without the need to give away any equity 

• Take advantage of the flexibility and predictability of borrowing money 

• Keep up with repayments, avoiding significant consequences that could impact your business’s operations

What is debt financing?

Debt financing is a way of funding your business by taking on debt. Potential sources of debt financing include taking out a business loan, using a business credit card or having a line of credit. 

Like personal debt, any debt your business takes on must be repaid, typically through monthly or weekly payments. Unlike equity financing, taking on debt does not require giving up any ownership in your business, and the repayment schedule is usually predictable, making cash flow forecasting easier.

Debt financing is usually obtained through external lenders that are not part of your business. This might be through a high-street bank, an online lender or peer-to-peer (P2P) lending. 

How does debt financing work

By leveraging debt, your business can access funds for day-to-day operations or to take advantage of growth opportunities. You retain ownership of your business, but you must ensure you keep up with any repayments to maintain financial stability. Here’s how it works:

Step 1: Identify a need

First, you need to work out what you need the money for. It might be to pay for some equipment, ease cash flow issues or expand your business. 

Step 2: Choose a type of debt

Next, you want to choose a form of debt that best meets your business needs. There are lots of options here, including business loans, credit cards, overdrafts, lines of credit, asset finance and invoice finance.

Step 3: Apply

The application process varies depending on the type of debt you choose. For example, a large secured loan typically takes longer to process than a credit card. However, the overall steps are similar.

You apply for a specific amount. The lender requests information about your business during the application and then conducts a credit check, either on your business or on you personally if your business is still in its early stages.

Step 4: Receive funds

If you satisfy the lender, it will approve the finance and release the funds. This occurs in different ways depending on the type of debt financing you choose. For example, a lender typically deposits a loan into your account, while a credit card usually arrives in the post.

Step 5: Use funds

Once you’re in receipt of the funds you can use them for your previously identified need. Some types of finance, like asset finance, might not result in you receiving any cash at all. In this case, the funds are usually sent directly to the asset seller, with you receiving the asset rather than the money.

Step 6: Repay funds

Once your lender approves your application, it should provide you with terms or a finance agreement. This document outlines what you need to repay, when payments are due and how much interest the lender will add.

It’s crucial to stay on top of repayments. Failing to do so can have serious consequences, affecting both your personal and business credit score. It could lead to the seizure of business assets too.

Types of debt financing

There are many different types of debt financing available, and not all of them will be right for your business. Knowing what’s available and how each option works is a good place to start. So, let’s explore some of the different types of financing out there:

Business loans – like a personal loan, a business loan is a sum of money that you can use for a range of purposes. You repay the loan over a period of time, known as the loan term, and the lender includes interest in your monthly repayments. Loans can be secured or unsecured. Some businesses may opt to use a personal loan over a business loan, but you should always make sure the lender is happy with this first. There are also startup loans, which are specifically for new businesses that are less than three years old.

Business credit cards – if you have a personal credit card, you may be familiar with how a business credit card works. The card has a spending limit, and any amount used accrues interest. You can choose to pay a minimum amount, a set amount, or the full balance each month. Which option you choose affects how much interest you pay. Business credit cards can help cover staff expenses and unexpected bills. They can also help build a credit score. Some cards even offer rewards on your spending.

Invoice finance – waiting for clients to pay their invoices can break a business, especially when payments are late. Invoice finance advances the cash from unpaid invoices, which can help regulate cash flow. The lender takes a cut of the invoice, but knowing you will receive the money can help when money is tight. You can continue to chase your client to settle the invoice, or you can pass that task on to the lender. 

Business line of credit – if you take the limit element of a credit card and the flexibility of cash you get with a loan, you’re looking at a business line of credit. A lender sets a limit that you can draw on, and they charge interest only on what you use, not on the full amount available to you.

Asset finance – this is a type of loan that’s used specifically for the purchase of a business asset. This could be a vehicle, equipment, some IT tech or a machine for your warehouse. The asset often serves as collateral, too, meaning the lender has some protection if you default on the loan in the same way it might with a secured loan.

Start Up Loan Scheme – managed by The Start Up Loan Company, part of the British Business Bank, a Start Up Loan is government-backed. You can borrow between £500 and £25,000 and pay no set-up or application fees. The interest is also fixed at 6%. Technically a personal loan, it can be a good way to finance your business in the early stages and take advantage of 12 months of free business mentoring.

Overdrafts – a common type of debt that’s usually taken out through your business bank account. An overdraft can help fund unexpected bills, but this type of borrowing usually has a high interest rate meaning it’s less suited to long-term use. 

Advantages and disadvantages of debt financing

Debt financing can be a business lifesaver, but it’s certainly not without its risks too. Here are some of the pros and cons of debt financing:

Advantages

• Retain control. You keep full ownership of your business meaning you can access the finance without giving up a stake in your business.

• Tax benefits. The interest payments on debts are usually tax-deductible. This reduces your overall tax burden.

• Fixed repayments. Debt usually comes with a clear and predictable repayment schedule, making it easier to plan finances and manage cash flow.

• Credit score boost. Successfully managing debt can improve and boost your business’s credit rating. This makes it easier to secure financing in the future and often at better rates.

Disadvantages

• Repayments obligations. You must always repay debt, even when times are hard. This can put pressure on cash flow, especially during slow sales periods and challenging times.

• Interest. Borrowing nearly always involves paying interest, which increases the overall cost of financing. Interest rates can also fluctuate if market conditions change.

• Credit risk. If you struggle to repay any borrowing, it can damage your business’s credit rating. This makes future borrowing more difficult and more expensive.

• Collateral. Many lenders require collateral, especially if your business is still young. This can put personal or business assets at risk because if you fail to repay the loan, the lender can seize the assets instead.

Alternatives to debt financing

There are several alternatives to debt financing. The most obvious is equity financing, where you give away shares or equity in your company in exchange for funding. You can do this through angel investors, venture capital firms, or crowdfunding platforms. 

You might also consider grants. Unlike a loan, you don’t need to pay back a grant. You can find grants through local government schemes and other organisations, but securing one can be challenging. The application process is highly competitive, and it may take a long time. Make sure you are eligible before applying, and take your time with the application to showcase your business in the best light. 

Bootstrapping is another popular alternative. This means using your personal savings to fund the business and/or reinvesting any profits back into it. Bootstrapping allows you to maintain full control and ownership without relying on external funding.