As a small-business owner, you will likely need extra cash to purchase inventory or hire help. Base on an overview of all most cases, debt financing is the right solution.
What is debt financing?
Simply put, debt finance is borrowing money from an outside source. It promises to pay the principal back plus a certain percentage of interest. When people think about this type of borrowing, they often think of banks. However, there are many other types of financing available to small business owners. These include micro loans or business loans, credit cards, and peer loans.
There are many pros and disadvantages to borrowing money from the outside. These must be carefully considered.
Let’s first look at the benefits of debt financing. While debt is often viewed as a negative thing, it can still be a positive aspect to your business’s bottom line. Let’s take a closer glance at these advantages.
The pros of debt financing
- You can keep ownership of your businessPerhaps you are tempted to find an angel investor for your expanding business. This is a good way to inject money into the business. But you need to ask yourself whether investors will interfere with your decision-making. If you want to be in control of your business, leverage debt financing makes sense. It involves borrowing money from a bank, or any other lender, and paying it back within the agreed-upon timeframe. Although they may charge you interest for the amount borrowed, they will not interfere in how you manage your day to day operations.
- Tax deductions
Taxes are often an important factor in deciding whether to use debt finance for your business. Why? The principal and interest payments on business loans can often be categorized as business expenses. These can be deducted form your business income taxes. You could consider the government your partner in your business by giving it a percentage (your tax rates)
- Lower Interest Rates
This is a difficult benefit to debt financing to understand but it can be quite beneficial. Tax deductions can have an impact on your overall tax rate. In some cases, taking on debt can have a tax advantage. Let’s say your bank charges you 10% interest on a business loan. The government taxes you at 30 percent. You can then calculate the following: Multiply 10 percent by (1-30%) to get 7 percent. After you have taken out tax deductions, your interest rate will be 7 percent instead of 10 percent. It’s a win/win decision that both you and your business can benefit from.
Debt financing: the pros and cons
- Repaying the Debt
It is possible to pay a bank or another lender without stress if your company has a steady flow of income. But what if sales are low? Or worse, what if you have to close your business? Your business will still be responsible for the debt. Business debt financing is a risky option for businesses that aren’t financially stable. In addition, lenders who are unable to repay you due to a bankruptcy will be able to claim your debt before equity investors.
- High Interest Rates
You may find that your parents are willing to lend you some money at a negligible interest rate. However, this is not the case for traditional banks or other lenders. Your credit history, type of loan and other factors can all impact the interest rate. However, even after subtracting tax deductions to calculate the discounted interest rate, you could still be paying a high monthly interest rate that reduces your profits.
- The Effect of Credit Ratings
Credit ratings are affected by the amount you borrow. This effect can be detrimental if you borrow large amounts. This results in higher interest rates, and greater risk for lenders.
- Cash Flow Challenges
Every business sells a different amount of products each month. In fact, many businesses have busy periods. Lenders typically require that any debt financing be paid in equal monthly installments. This can make it difficult to pay your debt on time. It can also lead to defaults or late payments that can negatively impact your credit score over the long-term. It is not a good idea if you aren’t sure you can pay the loan back.
When is debt financing appropriate for funding your business?
Kenny Rogers said in “The Gambler” that it is important to know when to hold and when to put them away. This holds true for debt financing. Although it isn’t for everyone, understanding the pros and cons of debt financing can help you make or break a business. These are the questions you need to ask to help determine whether this is the right move for your business.
- Will the funds be used to invest in variable and fixed costs?
If you invest in fixed costs like office furniture or equipment, you won’t receive any cash returns on the money you borrowed. When you consider the fact that the loan’s installment payments will begin soon after it is lent, this can make debt financing more risky. But, investing in variable costs like inventory or materials can bring you an immediate cash inflow.
- Which stage is my business at?
When you are just starting your venture, it is tempting to need cash in order to get the business off the ground. Debt financing can pose a risk to a startup. Before businesses turn a profit, almost all businesses lose their money. In the long-term, your credit rating can be affected if you don’t pay back a loan. Debt financing becomes more feasible as your business grows and you become more aware of the true value of your earnings. The chance of bankruptcy increases in the first few year of a business, but it decreases as the company continues to grow.
- Do my customers pay on-time?
Relying on customers to pay you on a timely basis so you can repay your loan is a risky proposition. You need to ensure that your customers are reliable. Too often, this isn’t true. Pay attention to how your customers pay. Offering financial incentives may help customers pay more early. You aren’t sure if the terms you offer your customers are fair? Ask for advice from others in your industry. Depending on industry payment requirements, you might be able to get more upfront or quicker payment.
- How organized am I to make regular payments on time?
Let’s face truth: There are not all business owners who can be considered financial wizards. While this doesn’t automatically mean you shouldn’t start your own business, it could be an indication that using debt financing could prove problematic, particularly if you are prone to forgetting to pay. This might be your preferred method of financing. We will explore other options.
When Debt Financing Doesn’t Make Sense
There are many options available to you if you need cash.
Grants provide money that you don’t need to repay. There are many grants available for small businesses. They are often awarded by government departments, foundations or trusts. Sometimes, they can also be given to individuals. The Small Business Administration will help you find grant opportunities as well as apply for grants. Online searches can be extremely helpful, particularly when searching for private grants offered by corporations or non profit organizations.
It is important to remember that this alternative to financing with debt can be expensive and there may not be enough grants available. This option is definitely available and can jumpstart your venture without you having to take on debt.
Are you passionate about a business idea and want to share it with others? Angel investment may be right in your case. You might be able, with a business plan in place and some chutzpah on your side, to get the funding you need by pitching the idea to the right people. Where can they be found? Start by going to industry events and mixers. This will allow you to get to know others in the business. The next step is to make connections and share your business plan. It can be thrilling to get an investor that believes in what your company is doing. However, they might also want to do more than just give money. Angel investors often want to take part in decision making and receive a check at the end. Angel investment has its own strings. This financing option is best avoided if you want to be your own boss.
Family and Friends
Many small businesses were started with financial help from relatives and friends through loans and financial gifts. Many of the most prominent companies in the world, including Microsoft and Virgin, have been helped by them. As with angel investments, you should expect that strings will apply if you decide to borrow money from your family. Clear understanding of the terms and conditions of the loan can make it easier to avoid any problems down the line.
There will be times when traditional methods of financing debt such as bank loans don’t cut it due to the time required to get the funds. Hire help is necessary to be able to finish a large or unexpected project. A supplier has made you a deal for inventory that can be quickly sold to make a quick profit. Perhaps you have a marketing opportunity that will help you quickly grow your company. Whatever your reason, a loan to a business might be the right option for you. Many small businesses have turned to Kabbage for help.
Kabbage provides a free signup, but there is no obligation. Kabbage offers a quick and easy way to get a loan for your business. This is a great debt financing option to keep in your pocket for when you have an urgent need. Kabbage doesn’t review your credit history to determine if you are eligible for funds. Instead, they review a wide range of data sources, including eBay and PayPal, shipping analytics and social media numbers. This is a good option for small businesses who are financially stable and need funds.
There are many financing options available to small businesses. You can make your business more secure and help pave the way to future growth by choosing the right type.