Small Business Debt Financing

While securing financing for your business is difficult, it’s certainly not impossible. Acquiring outside funding for small businesses can either be in the form of debt financing and equity financing (more on that later). These two primary forms of securing capital differ in one significant way: business ownership. When business owners opt for equity financing, they are essentially selling equity or ownership in the business in exchange for investments in their company. But what about debt financing?

What is business debt financing?

Business debt financing is money that you borrow from a financial institution that you agree to pay with interest. Think about it this way, if you’ve ever taken out a loan from a bank to finance a big purchase such as a house or a car, you’ve already financed something using debt financing. Some of the most common debt financing examples include traditional business loans, lines of credit, cash flow loans, and government-backed loans. Funding acquired from debt financing can be used by business owners to fund expansion projects, purchase new equipment, finance new business ventures, and even bolster working capital.

Small business debt financing definition: How does debt financing work?

Much like other types of financing, debt financing is a time-bound financial obligation that the borrower needs to pay back over a set period of time, with a fixed interest rate. Payments are usually made through monthly installments until the borrowed amount has been paid in full. Keep in mind that the specifics of your loan terms would likely depend on the type of debt financing you are applying for. For instance, there are some types of debt financing options that have variable interest rates as opposed to a fixed interest rate. It’s important to study each option available to be able to identify the loan that would best meet your needs.

What are the different types of debt financing available?

Unfortunately, there is no single correct choice when choosing a business loan. Each business is unique and a business’ financial needs differ from one company to another. As a business owner, there are several ways you can use debt financing that could help start your business or improve your existing operations. In this section, we’ll look over some of the financing options you may want to consider.

• Traditional term loans –  One of the most common options for businesses, a term loan is a type of financing option offered by traditional financial institutions such as banks and credit unions. It is available to both start-ups and established businesses to be used on a variety of business expenses. A term loan lets businesses borrow a fixed amount of money with interest and pay it back after a set period. What makes this debt financing option popular is that it makes it easier for businesses to predict monthly costs.
• SBA loans – It is important to understand that the Small Business Administration (SBA) does not directly lend money to small businesses. According to its official website, the SBA works with lenders to provide loans to small businesses. It also sets guidelines for the loans offered by its partnered lenders, community development organizations, and micro-lending institutions. SBA loans are known to reduce the risk for lenders and make borrowing funds much more accessible to small businesses. Some of the most common examples of SBA loans are the SBA 7(a) loan, the SBA microloan program, and its real estate and equipment loans.
• Revolving loans – A revolving loan is a line of credit offered by a financial institution that gives borrowers the ability to draw money, repay what’s borrowed, and access the funds again as needed. You also only pay interest on the amount borrowed and not the full amount available. This is in direct contrast to a term loan that provides borrowers with a lump sum with fixed interest and a set payment schedule. Business lines of credit and business credit cards are considered as revolving loans.
• Cash flow financing – Although it sounds complicated, cash flow financing is actually one of the most straightforward financing options available to businesses. Cash flow financing basically means a loan made to a company based on a company’s expected cash flows. Like term loans, cash flow loans involve a lump sum payment to the borrower. But instead of undergoing a thorough credit analysis, a financial institution studies a company’s cash flow when determining the loan’s terms. Cash flow loans can be used to cover regular business expenses such as payroll, rent, and other utilities.

What is the difference between debt and equity financing?

So when it comes to debt vs equity financing, is one really better than the other? As mentioned above, the biggest difference between debt financing and equity financing is business ownership. With debt financing, you borrow money from a financial institution and promise to pay it back. On the other hand, equity financing involves selling stake or ownership in your company to be able to secure financial backing from a prospective investor. However, before deciding if debt financing is right for you and your business, it’s important to understand why companies use debt financing.

Why do companies use business debt financing: The pros and cons

The most common misconception when starting a business is that debt is always a bad thing. While understandable, it’s not necessarily true. There are many reasons why business owners choose to go into debt rather than sell a stake in their company. One big reason is that business owners would want to maintain complete control of all of their business decisions. But is that the only reason why companies use debt financing? Let’s take a look at some of the advantages and disadvantages of debt financing.

What are the advantages of business debt financing?

• Debt interest costs are fully tax-deductible
• Can build-up your business’ credit score
• Predictable monthly payments (assuming that interest rates are fixed)
• Business owners keep control and ownership of their business with debt financing

What are the disadvantages of debt financing?

• Long-term debt financing options usually require collateral
• The application process tends to be more meticulous
• Business assets could be seized in the event that you become unable to repay your loan
• Qualifying for the loan you want depends on your business’ financial documents and overall creditworthiness

How to choose the right debt financing option for your business?

When choosing the right debt financing option for your business, it’s important to determine whether or not you will be able to qualify for a loan depending on your financial situation. You can start by asking yourself the following questions:

• How long have you been in business? The longer you’ve been in business, the higher the likelihood that lenders will approve your loan application. Small businesses or startups that have been operating for only a couple of months will have a much more difficult time finding a loan.
• What does your cash flow look like? Remember, financial institutions are lending you money knowing that you will be able to pay the amount back plus interest. Expect lenders to have minimum revenue requirements and ask you to submit proof that your business is healthy and profitable.
• Do you have the necessary documents to prove that you can pay back your loan? In addition to cash flow documents, your prospective lender may also ask you to present your personal and business tax returns, relevant financial statements, your business plan, and, if applicable, proof of collateral.

Once you have prepared all the necessary documents and feel confident about your chances of securing financing, it’s now time to familiarize yourself with the loans that you can qualify for. If you’re trying to get an idea about the types of debt financing options that your business can secure, use PrimeRates.

PrimeRates provides access to personalized loan offers through our simple and quick pre-qualification application. PrimeRates’ easy to navigate tool takes less than two minutes to complete which wouldn’t have an impact on your credit score. The pre-qualification process enables you to learn about personalized offers that you can compare based on interest rates, repayment terms, and loan amounts. After choosing the loan that would best meet your needs, you can then finalize your loan offer with your prospective lender. Note that you may be asked to submit relevant verifications such as IDs as well as other financial documents.