What is debt financing?
Debt financing is a form of business finance that involves a company borrowing money from a financer, like a bank or working capital funding organization. The borrowing company is then liable to repay the money they borrowed, plus interest or a set fee, over a set period.
Debt financing is one of the most common ways for businesses to raise capital in the short term. This capital can then be used for a variety of purposes, like fueling growth, investing in inventory, or covering a cash flow shortage.
There are lots of different types of debt financing arrangements to choose from, ranging from straightforward business loans to flexible invoice financing arrangements that allow businesses to raise money against their accounts receivable.
Each one has different pros and cons, but they’re all distinguished from another popular form of business finance: equity finance.
Debt finance vs equity finance
Equity finance is the opposite of debt finance. Where debt finance involves taking out a loan that must be repaid to raise access to working capital, equity finance involves selling shares of ownership in the business to external investors to get a cash influx.
Funds raised through equity finance don’t need to be paid back, unlike those raised through debt finance. However, equity finance dilutes the ownership of existing shareholders, meaning profits have to be distributed to a larger group of owners.
The following table sums up the key differences between debt finance and equity finance:
|A company borrows money from a lender and agrees to repay the loan, plus interest or a set fee, over an agreed-upon period.
|A company raises capital by selling shares of ownership in the business to external investors.
|The company retains full ownership of the business.
|The investors own a portion of the business, in-line with the amount of capital they invest.
|The company must repay the loan, plus interest, regardless of profitability, within a previously agreed financing term.
|Investors are not entitled to repayment of their investment unless the company is sold or liquidated.
|Debt finance is generally considered to be less risky than equity finance because the company is not giving up any ownership of the business. However, it does involve taking on temporary debt.
|Equity finance is generally considered to be riskier than debt finance, because investors are giving up ownership of the business in exchange for a share of its future profits and losses.
Types of debt financing
There are lots of different types of debt financing for businesses to choose from. These are three of the main options:
Business loans, whether they come from a bank, a credit union, or an organization like the Small Business Administration, are one of the most common debt financing methods.
They give companies the chance to borrow capital, which they can use to support their operational needs or fund expansion, for example. At the point the loan is provided, repayment terms are agreed on. The borrowing company then must repay the loan amount within those terms, with the addition of interest and/or fees.
Invoice financing, also known as accounts receivable financing, is a debt financing method that involves borrowing against the value of accounts receivable (or outstanding invoices).
It allows companies to get instant access to the cash they’re owed from customers, as opposed to waiting until the invoices are due. In the process, they incur a debt which is owed to the financer. When the invoices are due, the borrowing company either collects the money from their customers and repays their debt, or the financing company collects the money directly.
Invoice financing is a particularly valuable form of debt finance for funding working capital shortfalls, as it is quick, simple, and cheap. There’s generally no interest due on the debt, with a financing fee coming off the total amount instead.
Asset-based lending involves a company securing a loan using its assets, like inventory, equipment, or real estate, as collateral.
This collateralized approach means that companies can get access based on the value of their assets rather than their creditworthiness or financials. This means it’s a relatively popular form of debt financing for small or new businesses that are seeking a cash injection to grow.
Advantages of debt financing
While each specific form of debt financing has its own unique pros and cons, they all share distinct benefits compared to some other forms of business finance.
Retain business ownership
Debt financing allows businesses to gain access to capital without diluting their ownership of the company, as opposed to equity financing, which necessarily involves selling shares. This means that the company gets to keep all the rewards of its growth instead of having to share it with its financer, who becomes a shareholder.
Fuel growth with debt
Although an excess of debt can be toxic for a company, strategic debt can be instrumental in fueling growth. Businesses can use the funds they raise from debt financing to invest in research and development, make new hires, buy more inventory, or build resilience against a turbulent market.
If the revenue growth they experience because of their investment outweighs the repayment costs in the long term, the move can be considered positive.
A high degree of flexibility
Debt financing arrangements are generally highly flexible. Invoice financing agreements, for example, tend to give the borrowing company the choice of how many of their outstanding invoices to raise funds against. This is perfect for businesses that are looking for a form of financing that’s adaptable to diverse needs.
How to choose a business funding method
Choosing the right business funding method depends entirely on the circumstances your business is in and what your objectives are. Factors that will affect what the right choice for you is include:
- Your funding requirements
- Your business’s creditworthiness
- The value of your accounts receivable/assets
- Your risk tolerance
However, a method of debt financing will be a better fit for any company that doesn’t want to give up ownership for funding.
Out of the three main debt financing options – business loans, invoice financing, and asset-based lending – the choice really comes down to your specific needs.
If you’re looking for a longer-term financing solution and don’t mind paying interest, a business loan might be a good fit. Just remember, the interest payments will depend on the average interest rate at the time of your loan and your business’s credit rating.
If you want a cheap, low-risk, and flexible arrangement to boost your working capital in the short term, an accounts receivable financing solution might be the better choice.