Business management

Should you use debt financing?

What is Debt Financing?

Debt is borrowing money from an outside source at an agreed-upon level of interest. Although the term tends to have a negative connotation, startup companies often turn to debt to finance their operations. In fact, even the healthiest of corporate balance sheets will include some level of debt. In finance, debt is also referred to as “leverage.” The most popular source for debt financing is the bank, but debt can also be issued by a private company or even a friend or family member.

Advantages to Debt Financing

1.     Maintain ownership: When you borrow from the bank or another lender, you are obligated to make the agreed-upon payments on time but that is the end of your obligation to the lender, this may provide less outside interference.

2.     Tax deductions: This is a huge attraction for debt financing. In most cases, the interest on principal payments is classified as business expenses and thus can potentially lower taxes.

3.     Low Interest: In today’s economy, the low cost of borrowing makes it an interesting way to finance expansion without using up capital reserves.

Drawbacks to Debt Financing

1.     Repayment: Obviously there is an obligation to repay the lender; unfortunately even if your business fails, you will still have to make these payments. Also if you are forced into bankruptcy, your lenders will have claim to repayment before any equity investors.

2.     Impacts your credit rating: It might seem attractive to keep bringing on debt when your firm needs money, a practice knowing as “levering up,” but each loan will be noted on your credit rating. And the more you borrow, the higher the risk to the lender, and the higher interest rate you’ll pay.

3.     Cash and collateral: Even if you plan to use the loan to invest in an important asset, you’ll need to make sure your business generates sufficient cash flows to cover loan repayments.  Also the business may need to put up collateral on the loan in case you default on your payments. 

The option to debt financing obviously is to increase the owners’ equity in the business.  Since that may require the disposition of other assets to raise the cash, the most practical method may be adding to debt as long as the company can manage repayments and debt levels are prudently managed.