Businesses often require additional capital to start, grow, or manage business operations. To satisfy this need, businesses can pursue a variety of financing options, including debt financing. Debt financing usually takes the form of a loan from a bank or private lender. In the most basic debt financing structure, a lender provides capital to a business, which the business will repay to the lender over an agreed time period and with interest. However, it is important to note that debt financing extends far beyond the traditional bank loan. Examples of debt financing also include equipment financing, invoice financing, business line of credit, and more.
This article discusses the advantages and disadvantages of debt financing and factors businesses should consider when determining whether debt financing is appropriate to meet its needs.
Debt Financing Advantages
Control: Debt financing allows a business (i.e. borrower) to retain certain control over its business operations. Unlike other financing options, such as equity financing, a debt financing borrower is required to pay interest to the lender, but the lender is less involved in the management of the company.
Tax Benefits: Interest payments made in accordance with a debt financing transaction may be tax deductible. Other costs associated with financing a loan, such as origination fees, may also be tax deductible. If properly structured, the interest payments and other loan costs will help reduce the company’s overall tax liability.
Creditworthiness: Obtaining debt financing helps to establish a business’ record of creditworthiness. This will prove beneficial to a business in the future when it seeks to obtain bank loans at competitive rates.
Debt Financing Disadvantages
Hinders Growth: Debt financing may hinder a business’ growth. Debt financing requires businesses to repay both the principal loan amount and interest. Typically a business pursues debt financing to increase its cash flow. However, a certain portion of such increased cash flow must be used to repay the loan with interest at a time when the business needs the cash flow to satisfy other obligations and thereby hinder a business’ growth.
Collateral: A lender may provide either secured or unsecured debt financing. With respect to a secured debt financing transaction, lenders will ask businesses to pledge other company assets as collateral. If the company is unable to repay its loan, the lender may seize the pledged company assets.
Personal Guarantee: If a business does not have sufficient business collateral, the lender may also require a personal guarantee from the business owner. Accordingly, if the business is unable to repay the loan, the lender can seize both company assets and the business owner’s personal assets.
Accordingly, businesses should consider the following when determining whether debt financing is appropriate:
- Importance of retaining control of the business.
- Ability to make regular monthly payments.
- Qualifying for debt financing.
- Available collateral.
- Ability to personally guarantee.
The content of this post is for informational purposes only and should not be construed as legal advice or legal opinion. You should consult a lawyer concerning your specific situation and any specific legal question you may have.