What is Debt Financing and Should You Do It?
Borrowing on Credit
There are many reasons business owners may find themselves in the need of cash in addition to their regular business income. In fact, most successful businesses, at some point, at least consider taking out a loan in order to expand or grow their business. Business owners may seek loans from commercial lenders, friends, or family, or through other means with the intention of paying the loan back.
But what if you cannot pay it back?
Here is some basic information about borrowing money for your business and tips on how to ensure you don't get in over your head and get swallowed up in debt.
What is debt financing?
Debt financing is also known as borrowing on credit. The simplest meaning of debt financing can be defined as borrowing money on credit with a promise to repay the amount borrowed, plus interest.
Debt financing can come from selling bonds, bills, or notes to lending institutions (loans), individuals, and sometimes, to investors.
Sources of debt financing (borrowing on credit) include:
- Banks and Savings and Loan Institutions
- Commercial Financing Companies
- Personal Loans From Family, Friends, or Other Individuals
- State and Local Resources for Small Business Debt Financing
- Government Sources
Because banks and other lenders may be hesitant to offer long-term debt financing to small business owners, the SBA offers guaranteed lending programs.
These programs reduce financial risks to lenders making it easier for small business to obtain long-term debt financing.
The SBA’s programs may help you get a loan, but lenders will still look at owner equity (how much you have already invested in your business) and will likely require personal guarantee of repayment.
Should you debt finance your business?
If your business has a high equity-to-debt ratio (meaning you have a lot more assets than you do liabilities) the Small Business Administration (SBA) recommends debt financing as a viable way to finance a new business or to expand an existing company. However, if you already have a lot of debt, adding more may not be a wise choice for your business.
Whether or not you should borrow money for your business depends on two main considerations: terms of the loan and your ability to pay it back.
The terms of any loan will include when you will make payments, how much you have to pay with each installment, late fees, and how much in total, including interest will you need to pay the entire loan back. That amount (the grand total cost of repayment) needs to be compared with the urgency of the cash needed (the purpose) and whether or not the amount you borrow will work to generate enough income to meet your financial goals (including repayment of the loan. Some loans may have penalties for pre-payment, so be sure to factor in the total costs for early payment as well.
Personal Responsibility for Business Loans
The other consideration is what you have to put on the line in case you cannot repay the loan.
If you take out a personal loan and your business cannot pay it back, you will have to and if you don't creditors can come after you personally for repayment.
This is also true for certain types of business structures such as sole proprietorships in which and individual (the sole proprietor) and a business (sole proprietorship) are seen as one. In other words, a sole proprietor, for legal purposes, automatically assumes personally responsibility for debts taken out in the business name.
For example, say imaginary business owner, Yolanda Benjamin, decided debt financing would help her business grow. Yolanda was able to borrow on her own credit and took our a personal loan to cover expenses for her sole proprietorship. Even if the business goes under she will still have to pay back the business loan for her personal assets and income.
The Bottom Line
Never assume debt you cannot repay. That may sound like a no-brainer but there are many 'legal loan shark' type companies out there who will lend you money when banks don't. These lenders (i.e., car title loans and payday loans) prey upon people who are experiencing a short-term financial crisis.
If a bank turns you down, apply to another bank or credit card company, but if you are being turned down by reputable lenders it is most likely for your own good. Resist the temptation to take a loan out against your personal property (like a title loan) where the repayment terms will be extremely unfair to you and the consequences dire if you cannot repay the loan. Better to hold off on expansion, downsize a bit, or ask a family member or friend to help you out.
Just remember if you do borrow from family or friends to treat it as any loan and put the repayment terms in writing and stick to them. It is never worth ruining business or personal relationships over money matters.