Debt financing: Is it the right funding choice for your business?

Debt financing might not sound like the most appetizing way of funding your small or medium-sized business (SMB). But don't worry – it's not as intimidating as it sounds. 

Unfortunately, when you hear "debt," you probably don't think of it as a good idea. And it's true, a lot of businesses carry some form of it – only 28% of SMBs reported having no outstanding debt in the U.S., according to a 2022 survey published on Statista.

Bank loans, lines of credit, even credit cards – they all fall under the umbrella of debt financing, though. In fact, a 2023 survey by Forbes Advisor found that business loans are the most popular funding method, with 27% of entrepreneurs relying on them as their primary source of capital.

But here's the deal: you can't just grab any funding option and hope for the best. You need to understand the ins and outs, the different types, and what works best for your unique situation. This guide will explore all facets of debt financing so you can make smart choices for your business's financial future.

What is debt financing?

Debt financing – also known commonly as debt funding or debt lending – is a method of raising capital by selling debt instruments, such as bonds, bills, or notes. You receive a lump sum of capital upfront and then make regular payments to the lender over a predetermined period, typically with interest added on top.

Why do businesses opt for debt funding? The reasons are diverse:

• Bridging cashflow gaps: Industries with inherently slow payment cycles, such as international trade, often turn to debt lending to smooth out cashflow and cover operational expenses while awaiting customer payments
• Funding strategic moves: Whether it's a game-changing acquisition, a bold merger, or a significant expansion, these loans provide the substantial capital injections needed for major business maneuvers
• Navigating challenging times: Economic downturns or unexpected crises can put a strain on even the healthiest businesses. Debt funding can offer a lifeline, providing the necessary funds to weather the storm and emerge stronger on the other side.

How does debt financing work?

When a company needs a cash infusion, there are three primary avenues: taking on debt, selling equity (giving investors ownership), or a combination of both. Many business owners prefer the debt financing route to avoid relinquishing ownership and control.

So, how does a company actually do debt funding? It usually involves offering fixed-income products to investors:

• Issuing fixed-income products: Companies can raise capital by selling fixed-income products like:some text
  • Bills: Short-term debt securities, usually maturing in less than a year
  • Bonds: Longer-term debt securities, often with maturities of several years
  • Notes: Similar to bonds but can have varying maturities and terms
• Attracting investors: These products are sold to investors seeking a steady stream of income. The investors become lenders to the company
• Debt finance contract: The terms of the agreement, including the investment amount (principal), interest rate, and repayment schedule (maturity date), are clearly outlined in a debt finance contract
• Using capital: The company uses the capital raised to fund operations, expansion projects, or other strategic initiatives
• Repaying debt: The company is obligated to make regular interest payments to investors and repay the principal amount by the maturity date

Important note: In the unfortunate event of bankruptcy, lenders and bondholders take priority over company owners and stakeholders when receiving liquidated assets. This highlights the critical importance of timely debt repayment.

Example of debt financing

Simply put, think of debt financing as a loan. Let's say a popular high-street clothing chain finds itself facing a cashflow crunch. They have plenty of trendy stock but are experiencing a temporary shortfall of $10,000 to cover operational expenses and restock key items.

Instead of dipping into their emergency funds or missing out on sales opportunities, they decide to leverage debt lending by issuing bonds.

Twenty investors step forward and purchase bonds worth $500 each. This influx of $10,000 goes directly towards covering the store's immediate expenses and restocking popular products. In return for their investment, the bondholders are promised a 10% return on their investment, to be repaid within a 30-day grace period.

The store can restock its goods, pay bills, hit sales targets, and make enough money to pay back investors. At the end of the grace period, each investor receives a $550 return on their bond, giving them a small profit.

Advantages and disadvantages of debt financing

Debt financing offers many potential advantages for conscientious businesses, including:

• No changes in ownership: Bank loans, bonds, and notes aren't the same as giving equity – where businesses sell stakes in the company that grant them a degree of ownership. Owners can raise funds by incurring debt rather than conceding ownership rights
• Reduction in tax liability: Loan and bond repayments are typically tax deductible, so debt funding is more cost-effective than accruing expendable capital through methods like equity financing, for example
• Bolstering credit rating: If businesses pay loans and interest on time, their credit rating improves significantly. This means they’re better positioned to take out bigger loans to fuel further growth in the future
• Predictable payments: Debt financing involves fixed interest rates and repayment terms, making it easier to budget and forecast your finances. You know exactly how much you owe each month and for how long

While there are many advantages to this type of funding, there are also some potential downsides for unprepared businesses. These include:

• High interest rates: Since debt lending involves borrowing money, there are sizable interest rates attached. If managed improperly, this can lead to further financial problems
• Becoming reliant: Loans can stimulate growth and future asset purchases in the short term. However, businesses that rely on loans to keep them afloat as a long-term option will likely find themselves at risk of bankruptcy
• Can hinder your appeal: Perpetual loans alter your debt-to-equity ratio in a way that can make a business unappealing to prospective investors
• Debt repayment obligations: Debt, by definition, means you owe money. Regular loan payments can strain cashflow, especially for businesses with unpredictable revenue streams or during economic downturns

Read more: 5 tips for securing the capital you need to scale your business.

Short-term vs. long-term debt funding

The main difference between short-term and long-term debt financing is the length of time businesses have to repay the loans. However, there's more to the story than meets the eye. Each option comes with its own set of advantages and disadvantages, impacting your business's financial flexibility, risk profile, and overall cost of borrowing.

Short-term debt financing: Quick fixes and higher costs

Think of short-term debt lending as a sprint – it's ideal for addressing immediate needs, bridging temporary gaps, or seizing time-sensitive opportunities. These loans, typically repaid within a year, offer:

Advantages

• Speed and accessibility: Short-term loans are generally easier and faster to secure than their long-term counterparts, making them ideal for urgent situations
• Flexibility: Options like business lines of credit provide revolving access to funds, allowing you to borrow, repay, and reborrow as needed, offering flexibility for managing fluctuating cashflow

Disadvantages

• Higher interest rates: The trade-off for speed and flexibility is often a higher interest rate. Lenders perceive short-term loans as riskier due to the shorter repayment window
• Frequent renewal: Constantly renewing short-term loans can create administrative burdens and potential instability if loan terms change upon renewal

Long-term debt financing: Strategic investments and lower rates

Long-term debt funding is more akin to a marathon – it's strategically employed for significant investments, long-term growth initiatives, or asset acquisition. These loans, with repayment terms exceeding a year, offer:

Advantages

• Lower interest rates: The extended repayment period translates to lower interest rates compared to short-term options
• Predictability: Fixed interest rates and structured repayment schedules provide financial predictability, making it easier to budget and plan for the future

Disadvantages

• Higher qualification requirements: Lenders typically have stricter eligibility criteria for long-term loans, requiring a more robust financial track record and potentially collateral
• Reduced financial flexibility: Committing to long-term debt payments can reduce your financial flexibility, especially if your business experiences unexpected downturns

Types of debt financing

When it comes to securing funding for your business, understanding the different types of debt financing is crucial. But it's important to note that there isn't a single "right" way to categorize these options. You’ll find different approaches to group them based on factors like repayment structure, collateral requirements, or target audience.

Here, we categorized the types of debt lending in a way that helps clarify their key features and differences. Keep in mind that this list is not exhaustive.

1. Installment loans

Installment loans provide a lump sum of money upfront, which you repay over a fixed period with regular, predictable payments. These are common for both small businesses and large corporations, though the specific terms and requirements will vary.

• Term loans: These are the quintessential business loans, offering a set amount of money to be repaid over a predetermined term (e.g., 5, 10, 20 years) with regular payments and either fixed or variable interest rates
• SBA loans: Backed by the Small Business Administration, they offer favorable terms, including lower interest rates and longer repayment periods, to eligible small businesses
• Equipment financing: This type of loan is specifically designed for acquiring equipment, using the latter as collateral. Payments are often structured to align with the equipment's expected revenue generation

2. Revolving loans

Revolving loans provide flexible access to funds up to a predetermined credit limit. You can borrow, repay, and reborrow as needed. They may be ideal for managing short-term cashflow fluctuations.

• Business lines of credit: These offer a revolving line of credit you can draw from as needed. Interest is only charged on the outstanding balance, providing flexibility for managing short-term expenses and opportunities
• Credit cards: Credit cards provide a revolving line of credit for smaller, everyday business expenses. They offer convenience, potential rewards, and a way to build business credit, but often come with higher interest rates and fees

3. Cashflow loans

Cashflow loans are based on your business's projected future cashflow rather than primarily on collateral or credit history. They can be helpful for companies with strong revenue streams but limited assets to pledge as security.

• Invoice financing: If you have outstanding invoices from reliable customers but need immediate cash, you can sell those invoices to a third party at a discount
• Merchant cash advance (MCA): MCAs provide an advance on your future credit card sales. Repayment is typically made through a percentage of your daily credit card transactions

Read more: What are the best alternative business financing options?

Debt financing vs. invoice financing

While invoice financing (factoring) falls under the broad umbrella of debt financing, it's important to understand the nuances that set them apart. Both methods are effective in allowing businesses to accrue cash quickly, but they differ in how companies access capital and how the finance provider chases repayment.

Unlike debt funding – which relies on different types of loans for liquid cash – invoice factoring isn't a loan.

Invoice factoring involves selling outstanding customer invoices (account receivables) to a third party at a discounted rate to access liquid capital more quickly than waiting for payment.

However, while finance providers still offer immediate liquid capital to the business, they must chase repayment through the customer, and this depends on whether it’s the recourse or non-recourse type of financing.

Debt lending differs in the repayment structure, with the borrowing business required to pay the lender back directly from its cashflow, plus interest.

Debt financing vs. equity financing

Debt financing is taking out a loan. You borrow money from a lender and agree to pay it back over time with interest. Equity in business financing, on the other hand, involves selling a portion of your company ownership to investors in exchange for their capital.

Now, you might be wondering, what does that mean for me as a business owner? 

Think of it this way: debt financing is like taking out a loan from a friend. You get the money you need now, with the promise to pay it back later – with a little interest, of course. Your friend is just lending you the money; they don't get a say in how you run your business. You retain full control.

Equity financing is more like bringing on a business partner. They invest money in your company, but in return, they get a piece of the pie – a share of the ownership and future profits. This can be great for securing a large chunk of capital, but it also means sharing control and decision-making – you basically dilute your ownership.

Want to learn more about funding options that don't require giving up equity? Check out our guide: What is non-dilutive funding? Benefits and different types.

Is debt financing good for companies?

Debt financing is diverse and offers a range of options allowing you to choose the best fit for your company's unique needs and risk tolerance. Unlike equity funding, debt funding empowers you to secure the capital you need while retaining full ownership of your company.

"Debt" isn't usually the first word that gets your entrepreneurial heart racing. But as we've explored, this isn't about simply taking on debt – it's about making strategic decisions that empower your business.

It all comes down to the type of debt financing you'll use to fuel your growth. And for businesses engaged in international trade, that should often mean unlocking the power of invoice financing.

At Stenn, we don't wait for the future – we build it. We help businesses with a faster, more flexible way to access capital. Get funded, break free from restrictive payment terms, and watch your business soar.

Turn invoices into cashflow – today. Talk to us and make it happen.

Debt financing: Frequently Asked Questions (FAQs)

How much does debt financing cost?

There is no fixed cost of debt financing – repayment figures will change depending on the amount borrowed, the interest rates offered, and the time frame in which the debt must be repaid.

However, there is a formula for calculating tax rates:

Formula: Cost of debt = Interest expense x (1 - Tax Rate)

Since interest on debt is tax-deductible, in more cases than not, expenses are calculated on an after-tax basis.

Is debt financing a loan?

Yes, debt financing is essentially a loan. But each type of loan differs. Capital can either be accrued from a traditional bank loan or by issuing bonds and notes to prospective investors.

What are the reasons for debt financing?

There are many reasons why a company may want to access liquid capital by incurring debt. The main reasons are:

• Raising capital for growth in the form of expansions, mergers and acquisitions
• Working as a short-term option to cashflow problems
• Limiting the impact of potential issues like ownership and equity shifts
• Debt financing options are tax-deductible, making it a cost-effective option to access capital