Running your own business might seem like a dream come true, however there’s no doubt it comes with major challenges. Finding customers, managing staff, ensuring compliance, dealing with competition, managing risk and much more – you’re dealing with demands small to large every day. Failure is common, especially for new businesses, so what can you do to give your business exactly what it needs to grow and succeed? Debt financing could drive your business forward and give it the edge it needs to stay out of trouble.
What is debt financing?
Debt financing is when your businessborrows money to be paid back with interest to run your business, and you’ll have an agreed time frame for repayment. Unlike equity financing, you’re not raising money by attracting investors who then have a stake (and claim over profits) over the business. You maintain ownership and control over your business.
You can use debt financing for any aspect of your business, whether it’s working capital or to make an acquisition. Your repayments could be monthly, half yearly, or towards the end of the loan term, depending on your agreement.
Debt finance can be secured or unsecured against an underlying asset. Examples of debt finance include bank loans, overdrafts, mortgages, credit cards and equipment leasing or hire purchase. Note that with a business, debt financing interest, fees, and charges can be claimed against your business income.
Debt financing can be short term or long term. If you’re buying things like machinery, buildings, and equipment, the loan time frame could be longer than a year (and the asset used as security for the loan). Long-term debt finance can also beappropriate if you’re employing more staff.
In contrast, short-term debt financing – such as a line of credit or credit cards – might be used for daily operations like supplies, inventory, and wages. With this type of loan you might have an agreement to repay within a year.
As with any type of debt, an element of risk is involved so it’s important to consider how much debt you can sensibly take on and review your debt-to-equity ratio.
The benefits of debt financing
Debt financing isamong the most popular forms of financing. So, what makes it so widely used?
- Ownership and control – Unlike equity financing, debt financing allows you to retain complete control over your business. You don’t have to answer to investors, therefore there’s less potential for disagreements and conflict. Even if it’s a secured loan, you would give up only on the collateral (and not your business) if you were to default.
- Tax – Debt financing comes with tax benefits, helping you reduce your tax bill. Since debt financing is a business loan and not a private, personal loan, you can claim a tax deduction on fees, charges, and interest.
- Profit sharing – With debt financing, your key obligation is to make the agreed payments on time. This is in contrast to equity financing, where you have to share your business profits with the equity investors.
- Accessibility – Get the capital you need to grow your business through a relatively straightforward process. When compared to equity financing, debt financing tends to be less complicated because there’s less compliance and you don’t have to go through the process of screening equity partners or the convoluted process of negotiating and coming to an ownership agreement.
- Credithistory – You can use debt financing to establish a proven credit history to help your business secure other types of financing in the future.
- Planningandpredictability – You’ll know exactly how much you need to repay, which helps with budgeting and planning.
- Flexibility – You can secure short-term, medium-term, or long-term loans for an amount appropriate for your business’s needs.
Debt versus equity; which to choose?
While both debt and equity could help your business grow, it’s useful to consider the different implications they could have for your business.
Taking on debt means you’ll need topay back the money with interest, while equity means you’ll be sharing ownership and control. Debt won’t dilute your ownership interest. Additionally, you won’t need to share future profits of your business. As repayments and interest are more or less known in advance, you can easily plan your repayments. Debt is repaid at some point so unlike equity, it doesn’t include a permanent change to your business (ownership).
Additionally, equity is considered a high-risk investment whilst debt is considered low risk, even though equity financing means an injection of funds without loan repayment obligations. At the same time however, having a high debt-to-equity ratio could constrain your business growth because you’re paying a lot to service your debt. Another issue to consider is that debt finance is technically a loan or liability of your business. On the other hand, equity finance is technically an asset of the company, as the injection is considered the business’s own funds.
Exploring your business’s finance options
Understanding debt versus equity financing is vital when you’re exploring ways to finance your business. When weighing up one or the other, consider things like debt-equity ratio, ownership, control, repayments, and your business’s individual needs. If you’re using both types of financing, striking a balance between the two could optimise cash flow and ensure you’re getting an appropriate share of the profits.
If your business is experiencing financial difficulties, but you’re not ready to give up, consider entering voluntary administration and turning your company around. Contact our expert team and they’ll be able to help you with the next step.
Call us now on 1300 750 599.