Debt Financing is a common way for a company to raise funds for working capital or capital expenditures.
Debt financing is the opposite of equity financing. Equity financing is the issuing of ownership via stock to raise money. Debt financing is the selling of debt instruments to investors such as bonds, bills and notes. Debt must be repaid while equity does not.
Payment is made in the form of interest. The agreed payment period is between the company and the investor, which can range from monthly to annual payments.
Debt financing can be accessed either by secured loans or unsecured loans. Secured loans usually require collateral, which takes the form of company assets. Unsecured loans don’t always need this assurance but may charge for higher interests or loan only small amounts.
Every company has its own way of raising funds. Debt financing can be a choice because you don’t spend your company’s equity. However, some find the risks too high and prefer to pair small loans with the capital of the business.
Debt Financing Pros and Cons
The following is a list of pros for using debt financing.
Caters to every size and type of business
Founder retains ownership
Defined, known, agreed upon repayment terms
Debt Financing Options
There are many debt vehicles, including:
The most basic of lending credit: You borrow money and pay it back within the amount of time agreed upon with a fixed interest rate. These types of these loans are like familiar, traditional installment loans such as car loans and mortgages.
Business Line of Credit
Similar to a personal credit line, a line of credit is a one-time loan that is closed to the borrower on the borrower spends the amount of credit extended. However, unlike traditional loans, that have set monthly payments, most lines of credit do not.
The lender provides a specific credit limit to the borrower the way you would a credit card. The account is open and remains open so the borrower can use and reuse the credit. It is different from a loan as you are not charged interest on the loan amount until you draw money from the line of funds.
Small Business Administration (SBA) Loans
The Federal agency helps in the improvement of small-scale enterprises through loan access opportunities.
It is what it says. You apply for a loan to pay for specific equipment. While there is still balance on credit, that particular equipment is put up — or secured — as collateral.
This is a more advanced type of financing where other businesses can purchase your accounts receivable. You will be paid about 80% in advance, while they will buy most of the remaining 20% at a later date.
Merchant Cash Advance
Another of the more complicated types of debt financing is the merchant cash advance. The terms are simple. You are given a loan in advance, which you’ll need to pay along with a fee. However, the lender will automatically deduct a percentage of income from your company until full repayment.
In the hunt for your company’s best options, you will need to analyze these different options with the following factors you need to consider.
Debt Financing Requirements
Businesses must prove their credit worthiness before securing debt financing. While banks have different criteria there is some commonality in what affects their loan decisions.
Banks would like to know if you can pay for their loans Lenders will look at annual revenue and documents related to expenditures and payables. Banks also want to know your total gross income because the loan they offer is usually less than 12% of the former’s worth.
Banks have a friendlier relationship with customers they have known for years. It is easier to trust a borrower that they know repay their loans.
Availability of Liquid Assets
Banks would like to know your company’s average bank balance to see if you can pay for unexpected or emergency expenditures. Three months worth of total spending in cash is desirable
Banks also would like to see the personal loaning patterns of their borrowers. Credit scores in excess of 700 are desirable.
Information Lenders Will Want to See
You will need to assure banks you have met federal, state, and local licensing criteria. An industry-specific license may also appear in the requirements.
Proof of Business Ownership
For most formal lenders, only the owner of the business can ask for credit. If you are anything but a sole-proprietorship, you will need to have written authorization from your partners.
If you are a franchisee, a copy of the FFA agreement signed with the franchisor is a possible requirement.
Personal Tax Return
Lenders would like additional information on your behavior in paying taxes, especially if you are a new borrower.
Business Tax Returns
The last two to three years of tax returns will be enough to show the history of revenue in the long term.
The last three fiscal years’ worth of balance sheets should be ready for some lenders who will ask for it.
Profit and Loss Statements
The most current statement along with the last two years of profit and loss statements to show revenue and expenditures.
Business Banking Statements
Gather all pages of four to six months’ worth of bank statements. Do 12 months if your business has seasonality elements.
A business plan shows a well thought out strategy for the business, which lenders would like to know.
A sales forecast may help new or struggling companies provided the paper is thorough in its study.
Most Recent Accounts Payable Statement
An Accounts Payable statement gives more information on the debts of the company.
Business Debt Schedule
This document is an organized schedule of all amounts of loans and monthly dues paid by the company.
Customers show the strength of the business. Name, contact information, and total sales are the descriptions you should have on the list.
Accounts Receivables Aging Statement
You should prepare the most recent statement as it will show the quick return in cash flow.
Credit Card Processing Statements
Put together the last three to six months of credit card processing statements to prove lenders of your sales.
Cost of Capital
Whether its equity financing, debt financing or the two combined, there is a cost of raising capital.
Equity debt is the dividend payments made to investors.
Debt, of course, carries interest rates and repayments made to a bank or coupon payments made to bondholders annually.
The point for businesses is to ensure that the returns on their invested capital exceeds the cost of borrowing and ultimately generates positive earnings for investors.