Debt Financing - Pros and Cons

Managed well, it can be an effective vehicle to help grow your business

Farmer and Banker looking at crops.
The most popular source for debt financing is the bank.. Ben Bloom / Getty Images

What is Debt Financing?

Debt is borrowing money from an outside source with the promise to return the principal, in addition to 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

  • 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. You can choose to run your business however you choose without outside interference.
  • Tax deductions: This is a huge attraction for debt financing. In most cases, the principal and interest payments on a business loan are classified as business expenses, and thus can be deducted from your business income taxes. It helps to think of the government as a “partner” in your business, with a 30 percent ownership stake (or whatever your business tax rate is). If you can cut the government out of the equation, then it’s beneficial to your business.
  • Lower interest rate: Furthermore, you should analyze the impact of tax deductions on the bank interest rate. If the bank is charging you 10 percent for your loan, and the government taxes you at 30 percent, then there is an advantage to taking a loan you can deduct. Take 10 percent and multiply it by (1-tax rate), in this case, it’s: 10 percent times (1-30 percent), which equals 7 percent. After your tax deductions, you’ll be paying the equivalent of a 7 percent interest rate.

    Drawbacks to Debt Financing

    • Repayment: As mentioned above, your sole obligation to the lender is to make your payments. Unfortunately even if your business fails, you will still have to make these payments. And if you are forced into bankruptcy, your lenders will have claim to repayment before any equity investors.
    • High rates: Even after calculating the discounted interest rate from your tax deductions, as explained above, you may still be faced with a high interest rate. Interest rates will vary with macroeconomic conditions, your history with the banks, your business credit rating and your personal credit history
    • 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.
    • 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 will be generating sufficient cash flows by the time loan repayment starts. Also, you’ll likely be asked to put up collateral on the loan in case you default on your payments.

    Alternatives to Debt Financing

    • Equity financing: This involves selling shares of your company to interested investors, or putting your own money into the company.
    • Mezzanine financing: Lenders who set up this debt tool offer the business unsecured debt (no collateral is required). The tradeoff is a high interest rate, in the 20- 30 percent range. Plus there’s a catch. The lender has the right to convert the debt into equity in the company if the company defaults on payments. Despite the high interest rate, mezzanine financing appeals to entrepreneurs because it offers quick liquidity, and even though it can be converted to equity, the issuing bank usually does not want to be an equity holder, meaning they’re not looking to control the company.
    • Hybrid financing: Most likely you’ll turn to a combination of debt and equity financing to fund your venture. The question then becomes: What is the proper combination? When deciding optimal capital structure, a common finance theory is the Modigliani-Miller theorem, which states that in a perfect market, without taxes, the value of a firm is the same whether it is financed completely by debt or equity or a hybrid. This, however, is considered too theoretical since real companies do have to pay taxes, and there are costs associated with bankruptcy. There are several other theories and formulas on determining optimal capital structures.

    Debt/Equity Ratio

    This is simply dividing your total debt amount by your total equity amount. Both lenders and investors will want to see this number to get an idea of how financially viable your firm is and where their investment stands in case your firm goes bankrupt, since debt holders get priority over equity-holders in recovering funds during bankruptcy.

    You will most likely take on some debt in the early stages but make sure to monitor how “levered up” your firm is, compared to the rest of your industry. Bizstats.com offers an easy way to gut-check your debt-to-equity ratio against a list of industry benchmarks. Reading this list shows investment banking is among the more risk-seeking industries, with a ratio of 29, while the electrical equipment industry comes in at a conservative 0.7.

    When to Use Debt Financing

    As mentioned above, the lender will be seeking installment payments on his loan shortly after the money is lent. That means in order to begin making payments you will need cash. Even a thriving business can be short on cash if its money is tied up in equipment, or customers aren’t paying. When considering debt, ask yourself:

    • Am I using this money to invest in fixed or variable costs? If you’re investing in fixed costs, such as a new piece of equipment, then you likely won’t see any cash returns from it in the near-term. If you need the money to invest in variable costs such as materials for the product you make or costs associated with each new client, then the debt investment should have associated cash inflow
    • What are my customers like? Customers who consistently pay on time are critical to cash flow and the ability to repay debt. Learn the payment habits of your customers and consider incentives to get them to pay early. Also, check with associations and competitors to make sure your payment terms are in line with industry standards.
    • Where am I in my business lifecycle? In the early stages of a firm, debt financing can be dangerous. You will likely be losing money at first, thus hurting your ability to make payments. Also, since your net income will be low, the tax advantages of debt will be minimal. As your business grows and matures, debt becomes a stronger option. The tax advantage will be greater, your cash flow will be more predictable, and the risk you face in bankruptcy decreases since you have been operating longer.

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