Debt financing is a source of finance for your business. This is different from equity financing, where you raise money from investors, who will be entitled to your profit shares. Debt financing can be short-term as well as long-term, depending on what you are financing goals are.
Let’s understand how debt financing works and how it can help you manage your business better-
Types of debt financing
Here are some examples of debt financing to help you understand the concept better-
Long-term debt financing
Long-term debt financing is generally for significant purchases for your business like buildings, equipment, materials, or lands. Lenders usually require long-term funding to be secured using the purchased items as collateral.
You will be required to make monthly repayments with fixed interest rates. For long-term finances, lenders usually have a 5 to 7 year timeline in which you must repay the entire amount. If you fail to pay off the loan, the lender will cease the asset you purchased with the financing.
Long-term debt financing is predictable, with fixed monthly repayments and interest rates. Hence, some businesses prefer this over other financing options.
Short-term debt financing
This is when businesses apply to borrow money for their day-to-day operations instead of some significant investment. This applies to inventories, purchasing supplies, and employee wages. These are known as short-term loans or operating loans because they require you to pay off the debt in less than a year. One such example of short-term financing is lines of credit. A line of credit can be both secured and unsecured in nature. Often people get confused between lines of credit and credit cards. Knowing the difference between a line of credit and a credit card can help you choose wisely for your debt financing needs.
Short-term debt financing is ideal for businesses with frequent cash flow issues when their revenue decreases significantly.
Sources of debt financing
Private sources for debt financing are banks, credit unions, friends & family, consumer finance companies, trade credits, leasing companies, and commercial finance companies. As for public sources, there are many debt financing programs offered by respective governments, both state and federal, for small businesses.
Small Business Investment Companies also offer direct loans along with equity investments.
Advantages of debt financing
The most significant advantage of debt financing over equity loans is that the lender will have no possession over your assets. You will be the sole owner as long as you pay off the amount. The debt interests are also completely tax-deductible as business expenses, and for long-term financing, the repayments spread over the years, which drastically reduces your monthly repayments.
Some other advantages of debt financing-
1. Builds business credit with successful repayments
2. Provides stability in budgeting
3. Allows you full ownership of your business
Debt financing is a popular choice when it comes to managing your businesses. Unlike equity loans, you won’t be obliged to allow others to have shares in your industry. Long-term debt finances are usually more preferred than short-term as the repayments span over 5 to 7 years with the most lender. This reduces your monthly repayments and lets you budget the entire amount more wisely. We hope this helps you understand how debt financing works and which sources might be best for you.