Debt Financing Definition

Debt Financing refers to raising capital by borrowing money from external sources, such as loans or bonds, which the company is obligated to repay with interest over a specified period.

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Debt financing, in plain language, means borrowing money to run or grow your business. With debt financing, you borrow money and promise to pay back the principle (the amount your borrowed) plus interest. The financing agreement specifies the amount of interest and a time schedule for repaying the debt. Once you pay back the principal and interest, you have no further obligation to the organization or individuals who loaned the money (the creditors). 

Companies use debt funding for working capital (short-term expenses such as business operational costs and buying inventory) and for capital expenditures such as buying an expensive piece of machinery, buying a building, or acquiring other companies.

Types of Debt Financing

There are many types of debt financing available to small companies that qualify. Among them:

  • Bank installment loans
  • Lines of credit 
  • Credit cards
  • Vendor financing (trade credit)
  • Equipment loans
  • Real estate loans
  • Factoring
  • Inventory financing
  • Merchant account financing
  • Government-guaranteed loans (small business administration loan program)
  • Loans from family and friends
  • Bridge loans
  • Cash flow loans (loans that are based on and paid off through your cash flow)

Depending on circumstances, the loans made to you will either be secured (require you to put up collateral), or unsecured (requiring no collateral.)

Debt Financing vs Equity Financing

The differences between debt financing and equity financing involve the obligation to repay the money and ownership of the business. 

Debt financing, no matter what form it takes, is basically a loan. The borrower is required to pay off the loan according to the terms of the loan agreement. The lender is entitled to nothing more than the return of their principle plus the agreed upon interest. The lender doesn’t own or control the business.

In contrast, equity financing is a way to raise money by selling ownership (shares) in a company. With equity financing, there’s no guarantee of repayment. Instead of getting a guaranteed payback of their investment, investors get a percentage of the business profits once it becomes profitable. Their percentage of profits will depend on numerous factors including the valuation of your company and percentage of the company’s shares they own. In addition, depending on the size of their investments, investors may become advisors to the company. They may also become involved with or even take over management decisions. 

Advantages of Debt Financing

Here are the reasons debt financing can be beneficial:

  • It lets your business get funding without having to give up any ownership or control of the business.
  • There are no additional payments once the debt is paid in full. 
  • The business doesn’t have to share any future profits with the lender.
  • Depending on circumstances and the amount needed, it might be faster and easier to get debt funding than it would be to get investors to give you money.
  • The interest on a business loan is tax deductible.

Disadvantages of Debt Financing

  • Your business, and/or you personally, must have a good enough credit rating to be able to qualify for financing.
  • You’ll need the cash flow and discipline to to repay the debt on the schedule specified in your agreement. If your agreement calls for monthly payments, you have to make those payments even if you have a seasonal downturn or a major customer is late paying you.
  • You may have to put up collateral. Collateral is an asset of value (such as a home, a major piece of machinery, or other property) that a borrower can take away from you or your company if you default on the loan.
  • You may have to sign an agreement saying you will be personally responsible for paying off the debt if the company defaults. By signing such an agreement means you’ll lose the LLC or corporate liability protection for that particular debt. If the business doesn’t pay, you, personally, will have to.

Debt Financing Considerations

Factors that will determine if debt financing is the right option for your business’s funding needs include:

  • Will the business be able to qualify for a loan or other types of debt financing?
  • Will the company be able to repay the debt under the terms of the loan agreement?
  • Are you willing to personally guarantee the debt if required by the lenders?
  • Are you opposed to giving up any ownership rights in your business?

We can help

Learn about the valuable resources ZenBusiness offers small businesses. We can help you with your business formation needs and provide you with needed services to start, run and grow your business. 

As a small business owner, staying on top of your business’s finances is essential. Make the job easier by using ZenBusiness Money to invoice customers, keep an eye on receivables, and keep track of all your tax-deductible expenses.

Disclaimer: The content on this page is for information purposes only and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.

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Written by Team ZenBusiness

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