Debt Financing, is when a firm gets money from other businesses or sources. This can be through selling of bonds, bills, or notes to individual and/or institutional investors. In simple terms, it is cash that you borrow to run your business. Debt financing, can be divided into two categories depending on the type of loan you seek to acquire, be it long term or short term.
Forms of Debt Financing
Long Term Financing
Long-term debt financing applies mostly to assets your business is purchasing, like equipment, buildings, land or machinery.
How it works: Long-term schedules repayment of the loan and the estimated useful life of the assets extends over more than a year. Normally, the lender will require that long-term loans be secured by the assets to be purchased.
Short-Term Debt Financing
Normally, Short-term applies to money needed for the day-to-day operations of the business, like purchasing inventory, supplies, or paying the wages of employees. Short-term debt financing is also referred to as an operating loan or short-term loan, owing to scheduled repayment that takes place in less than one year.
An example of short-term financing, is a “line of credit”.
How it works:Businesses that tend to have temporary cash flow issues when sales revenues are insufficient to cover current expenses,aretheones thatuseShort-term financing the most. A popular source of short-term financing for small businesses is a credit card.
Merits of Debt Financing
The good thing about debt financing is that the lender does not take an equity position in your business. Thus you retain full ownership and the lender has no control over the running of the business.
Debt interest costs come fully tax-deductible as a business expense. For long-term financing, the repayment period can be extended over several years, which reduces the monthly expense.
Demerits
Banks most times, require assets of the business to be posted as collateral for the loan for extended financing. This means that if your business does not have sufficient collateral, the lender will need personal guarantees from the business owners.
As a business owner, you are faced with the responsibility of paying back the loan (even if your business is incorporated). If your business faces difficulty and you are unable to make the loan payment, any personal assets you have posted as collateral stands a chance of being seized by the bank.
With debt financing your business may find it difficult to expand, because of the fixed repayment schedule and high cost of loan repayment.
Be it as it may, every loan has a bright side as well as not so bright side to it. But at the end of the day it depends on how you can use it to your advantage.