Following our blog on equity financing last week, let us now consider debt financing as a strategy for sourcing capital.
Debt financing is simply the process of borrowing funds for business with an agreement to pay back within a given time frame. The borrowed fund is subject to interests that are being paid alongside the principal amount. Businesses in need of huge capital outlay usually opt in for debt financing where they sometimes attach their company’s assets as collateral for a loan.
Debt financing can take the following forms:
Loans: This is the most common option for debt financing. Businesses can get a loan from either a commercial bank or other financial institutions after pledging a personal asset (in the case of a new business), the company’s asset or both as collateral. Loans can be for a short, medium or long term depending on the financial need of the business and are subject to periodic interests.
Bond issues: This option of debt finance is suitable for businesses that are well established and require funds for long term projects or expansion. It is usually raised by selling bonds to the general public and sharing profit on the bond issued. Bonds may last for a very long period depending upon the agreement.
Trade credit: This is a short term debt finance option whereby businesses (especially those starting-up) can purchase goods and pay later. There is usually an agreement between the vendor and business for granting this service.
Installment purchase: This has to do with purchasing capital items, such as a building or equipment, and making periodic payments. It is also another form of debt finance, where the item is mortgaged until full payment is made.
The benefits of debt financing over equity include:
Maintaining ownership of business - once the debt is fully paid, the owner does not have to share ownership rights with the lenders.
Interest paid on the loan is deductible from tax.
Whereas the disadvantages include:
Collateral - the business owner is usually required to pledge a personal, company's assets or both as collateral for a loan and risks losing these assets if unable to meet payment obligations.
Payment of principal and interest on a loan may pose a burden on the cashflow of the business.
Too many loans might have a negative impact on the credit ratings of a business.
It is important to consider all your options when it comes to obtaining finance for your business. Also, developing a strategy for financing your business is a good practice to ensure you are on the right track.
If you or your business requires support in choosing a capital strategy, email us at email@example.com for consultancy.