Debt Financing: Pros and Cons
When you borrow money from an outside source and promise to return the principal in addition to an agreed-upon percentage of interest, you take on debt. The term "debt" tends to have negative implications, but startup companies often find that they must acquire debt so they can finance operations. In fact, even the healthiest of corporate balance sheets will typically include some level of debt. Debt is also referred to as “leverage” in finance.
Banks are the most popular source of debt financing, but debt can also be issued by a private company or even by a friend or family member.
Advantages of Debt Financing
- Maintain ownership: You become obligated to make the agreed-upon payments on time when you borrow from the bank or another lender, but that's the end of your obligation. You retain the right to run your business however you choose without outside interference.
- Tax deductions: This is a huge attraction for debt financing. In most cases, the principal and interest payments on a business loan are classified as business expenses and they can, therefore, be deducted from your business's income at tax time. It helps to think of the government as a “partner” in your business in this case, with a 30 percent ownership stake or whatever your business tax rate is.
- Lower interest rate: Analyze the impact of tax deductions on the bank interest rate. If the bank is charging you 10 percent for your loan and the government taxes you at 30 percent, there's an advantage to taking a loan you can deduct.
Drawbacks to Debt Financing
- Repayment: Your sole obligation to the lender is to make your payments, but you'll still have to make those payments even if your business fails. And your lenders will have a claim for repayment before any equity investors if you're forced into bankruptcy.
- High rates: Even after calculating the discounted interest rate from your tax deductions, you might still be faced with a high-interest rate because these will vary with macroeconomic conditions, your history with the banks, your business credit rating and your personal credit history.
- Impacts on your credit rating: It might seem attractive to keep bringing on debt when your firm needs money, a practice knowing as “levering up,” but each loan will be noted on your credit report and will affect your credit rating. The more you borrow, the higher the risk becomes to the lender so you'll pay a higher interest rate on each subsequent loan.
- Cash and collateral: Even if you plan to use the loan to invest in an important asset, you’ll have to be sure that your business will generate a sufficient cash flow by the time repayment of the loan is scheduled to begin. You’ll also most likely be asked to put up collateral to protect the lender in the event that you default on your payments.
Alternatives to Debt Financing
- Equity financing: This involves selling shares of your company to interested investors or putting some of your own money into the company.
- Mezzanine financing: This debt tool offers businesses unsecured debt – no collateral is required – but the tradeoff is a high-interest rate, generally in the 20 to 30 percent range. And there’s a catch. The lender has the right to convert the debt into equity in the company if the company defaults on payments. Mezzanine financing appeals to entrepreneurs because it offers quick liquidity, and the issuing bank usually does not want to become an equity holder even though the debt can be converted to equity. They're not looking to control the company.
- Hybrid financing: Many companies turn to a combination of debt and equity financing to fund their ventures. The issue then becomes determining the proper combination? A common finance theory is the Modigliani-Miller theorem which states that in a perfect market, without taxes, the value of a firm is the same whether it is financed completely by debt, equity or a hybrid. But this is considered to be too theoretical because real companies have to pay taxes and there are costs associated with bankruptcy.
Debt/equity ratio simply means dividing your total debt by your total equity. Both lenders and investors want to see this number to get an idea of how financially viable your firm is. They'll want to know where their investment stands in the event that your firm goes bankrupt. Debt holders have priority over equity holders in recovering funds from bankruptcy.
You'll most likely take on some debt in the early stages, but monitor how “levered up” your firm is compared to the rest of your industry. Bizstats.com offers an easy way to check your debt-to-equity ratio against a list of industry benchmarks. Banking is among the most risk-seeking industries with a ratio of 29, while the electrical equipment industry comes in at a conservative 0.7.
When to Use Debt Financing
A lender will seek installment payments on its loan shortly after money is lent. This means you'll need cash to begin making payments in relatively short order. Even a thriving business can find itself cash-short when its money is tied up in equipment or if customers aren’t paying. When you're considering taking on debt, ask yourself:
- Am I using this money to invest in fixed or variable costs? If you’re investing in fixed costs such as a new piece of equipment, then you probably won’t see any cash returns from it in the near term. But if you need the money to invest in variable costs such as materials for the product you make or costs associated with each new client, the debt investment should have associated cash inflow.
- What are my customers like? Customers who consistently pay on time are critical to cash flow and your ability to repay debt. Take note of the payment habits of your customers and consider incentives to get them to pay early. Check with associations and competitors to make sure your payment terms are in line with your industry's standards.
- Where am I in my business lifecycle? Debt financing can be dangerous in the early stages of a firm. You'll probably be losing money at first and this can hurt your ability to make payments on time. Your net income will be low so the tax advantages of debt will be minimal. As your business grows and matures, debt becomes a stronger option. The tax advantage will be greater, your cash flow will be more predictable, and the risk you face in potential bankruptcy decreases since you have been operating longer.