Explanation of Debt Financing

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Debt Financing – If you are a small business owner, you will most likely eventually need extra cash to buy inventory, hire people, or buy equipment that will streamline your process. In most cases, debt financing is the solution.

Debt financing is when you borrow money to run your business, as oppose to equity financing, where you collect money from investors who in return are entitle to a share of the profits from your business. Debt financing can be divide into two categories base on the type of loan you are looking for.

What is Debt Financing?

Debt financing is the acquisition of funds by way of debt or borrowing money to finance business activities. In debt financing, you as a debtor have an obligation to pay a number of installments consisting of the principal of the loan along with interest.

Some Examples of Debt Financing Include:

  • Traditional bank loans
  • Personal loans
  • Loans from family or friends
  • Government loans
  • Peer-to-peer lending
  • Home equity loans
  • Line of credit
  • Credit card
  • Equipment loans
  • Real estate loans

How Debt Financing Works

Debt Financing Is Divide Into Two Categories Base on the Type of Loan, Namely As Follows:

Long-Term Debt Financing

Long-term debt financing generally applies to assets your business purchases, such as equipment, buildings, land, or machinery. Lenders will usually ask for a long-term loan to be secure with the asset to be purchase.

With long-term debt financing, scheduled repayment of loans and estimated asset useful life are often extended for a period of three to seven years. Long-term debt will most likely have a fixed rate converted into consistent monthly payments and high predictability.

Short-Term Debt Financing

Short-term debt financing usually applies to money needed for day-to-day business operations, such as buying supplies or paying employees’ wages. It is referred to as an operational loan or short-term loan because scheduled payments take place in less than a year.

Debt Financing Function

Generally, every company submits debt for business activities. One of them is to pay off the bill. Here are some other functions of debt financing that you need to know:

Business Travel Expenses

In large-scale companies, debt will be used as business travel financing in business development. Later, the funds will be used for booking airline tickets, car rentals, to hotel accommodation.

Internal Payments

The debt can also be used to finance the company’s internal needs accompanied by a receipt. For example, parking fees, fuel purchases for kitchen needs, such as snacks, and company meeting consumption.

Creditor Payments

Not always the company buys the necessary goods in cash, but in installments to vendors or creditors within a certain period of time. The debt will be used to pay off external payments before it enters maturity.

Debt Financing System

Basically, business debt will increase if there are transactions that are not recorded permanently in the company’s cash statements. Therefore, it is necessary to carry out a number of processes so that business debt can be handled properly. Among them are as follows:

Billing Receipt

When a company receives an invoice from a creditor, the company must check the validity of the bill first, both from the number of transactions to the repayment terms. Later, this bill will be useful in tracking the total goods received.

Review Billing Details

Detailed billing checks are mandatory for all companies. This is so that there are no errors in recording financial statements. What needs to be considered is the name of the vendor and the due date in accordance with the agreement.

Timely Payment

Payment of installments of business debt is an irregular cash outflow. All debt repayment must be made before entering the bill due date. Make sure the nominal on the check or bank account of the vendor is ready and verified.

Advantages of Debt Financing

The main advantage of debt financing over equity financing is that the lender does not take an equity position in your business. You retain full ownership and the lender has no control over the course of the business.

The interest expense of debt is fully tax-deductible as a business expense, and in the case of long-term financing, the repayment period can be extended for many years, reducing monthly expenses. Assuming the loan does not have a variable rate, the interest expense is a known amount for budgeting and business planning purposes. Other advantages include:

  • Building business credit
  • Exerting influence on the owner’s equity
  • Provide stability in budgeting and planning for the future
  • Long-term debt can eliminate reliance on more expensive short-term options.

Loss from Debt Financing

For extended financing, banks usually require business assets to be placed as collateral for loans. If the business does not have enough collateral, the lender will ask for personal guarantees from the business owner.

As an owner, this makes you personally responsible for repaying the loan, even if your business is incorporated. If your business cannot make loan payments, any personal assets you provide as collateral such as houses, cars, and investment accounts can be seized by the bank.

With debt financing, a fixed repayment schedule and the high cost of loan payments can make it harder for a business to thrive. With equity financing, money is invested in the business in exchange for equity. There is no fixed payment schedule, and investors generally have a long-term return on investment goal.

If your business needs debt financing or equity investments, you should have a solid business plan before lenders or investors consider providing you with funds. This includes financial details of your business, such as income statements, cash flow projections, and balance sheets.

Paying Back Debt

Making payments to banks or other lenders can be stress-free if you have a lot of income flowing into your business. But, what if sales go down? or, worse, what if your business fails? You will still be in debt.

Business debt financing can be a risky option if your business is not fully successful. If you are forced to go bankrupt due to a failed business, your lender will have a payment claim before an equity investor in your business.

High-Interest Rates

Your parents may be willing to lend you a certain amount of cash at almost no interest rate, but don’t expect this from a traditional bank or another lender.

Interest rates of course vary on a variety of factors including your credit history and the type of loan you are trying to get. However, even after calculating the discounted interest rate of your tax deduction, you may still pay a high-interest rate each month that cuts your profits.

Influence on Credit Rating

What you borrow does affect your credit rating. This effect can be negative if you borrow large amounts. This also results in higher interest rates and greater risk on the part of the lender.

Cash Flow Difficulties

Not all businesses sell the same amount every month. In fact, most have busier periods of time than others. However, lenders usually expect repayment on debt financing in the same monthly installment.

This can be a real challenge that can lead to late payments or even defaults that can jeopardize your credit in the long run. If you are not absolutely sure that you can repay the loan, it is not a good idea to get it.

Equity Financing vs Debt Financing

Businesses usually have two financing options to consider when they want to raise capital for business needs such as equity financing and debt financing. Debt financing involves borrowing money. Equity financing involves the sale of a portion of the equity in the company.

While there are different advantages to both types of financing, most companies use a combination of equity and debt financing. The most common form of debt financing is loans.

Unlike equity financing, which carries no repayment obligations, debt financing requires the company to repay the money it receives, plus interest.

However, the advantage of a loan (and debt financing, in general) is that it does not require the company to hand over some of its ownership to shareholders.

Conclusions about Debt Financing

Companies use debt financing to lower their capital costs, which in turn increases their returns to shareholders. Another advantage of debt financing is that, unlike equity financing, it does not weaken ownership.

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Interest on debt is also tax-deductible, which results in an increase in reported net income. However, debt financing exposes the company to adverse changes in interest rates.

Any increase in interest rates reduces net income. Companies should choose debt financing carefully based on their cash flow, their ability to meet interest obligations, and the percentage of debt in their total capital. Thus the article I can make about debt financing is hopefully useful, thank you.


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