Debt financing

Debt Financing: What It Is and How It Works

Debt financing is one of the sources that an entrepreneur can use to fund his or her business. Here, you will learn how it works and get an overview of the different types of debt financing available today.

The Basics of Business Financing

So, you’re interested in financing your business? Here are some of the basics to learn:

1. Introduction Into Business Financing
2. How to Prepare Your Business for Financing
3. Equity Financing
4. Debt Financing
5. Grants
6. Crowdfunding
7. Presales (Generating Revenue)

What is Debt Financing?

Debt Financing is a time-bound activity for raising money for capital expenditures by selling debt instruments, such as bonds, bills, notes, etc. to financial institutions that from now on will become the real creditors. Basically, it implies any kind of a loan.

The main requirements are regular monthly, quarterly or annual payments until the debt is completely paid off.

The most common forms of Debt Financing:

  • Bank Loan 
  • Federal Funding (SBA loan)
  • Credit Unions and Community Development Finance Institutions
  • Peer-to-peer loans
  • Lines of credit

Principal and Interest Rate

You will have to give a  promise to repay those two things by the agreed date in the future, so you need to understand the definition of each of them.

Starting with the principal, this is the amount of money you will get that must be repaid. Pretty simple.

The interest rate (or nominal rate) is a bit more complicated. It is an additional charge that the borrower has to pay the lenders for using their assets. 

This is some kind of compensation for the lenders as during the loan period they could invest their assets in something else and, probably, gain more money. After calculating the real interest rate for the period of your loan, they will give you a specific percentage of the total amount of the lent money. So you have to repay the principal and the percentage. 

In most cases the debt interest is tax-deductible. 

The amount will vary depending on whether the lender considered you as a high or low risk borrower. 

The formula of your final repayment will be:

Principal + (Interest rate (%) x Principal)

Covenants and Default

Covenants are the rules in the agreement between the lender and the borrower about the bond issuer’s performance.

Types of the covenants:

  • Negative (restrictive covenants). So-called restrictions. The most common example is banning additional borrowing until complete repayment of the current loan.
  • Positive (affirmative covenants). Specific requirements that the borrower has to meet: meeting financial obligations, paying taxes, furnishing financial statements to the lender, etc.

Violation of these rules will be considered as a technical Default — failure to repay the debt. The lenders usually calculate the default risk in advance. Some of them can even ask for a personal guarantee promise to create some kind of a safety cushion to make sure the debt will be paid off.

Main Types of Debt Financing

Debt Financing can be:

  • Long-term: loans for equipment, buildings, land, etc.
  • Short-term: loans for inventory, supplies, paying wages, etc.

And also:

  • Secured — providing a financial institution with a specific collateral (valuable assets or personal guarantee). In case of default, the lender will keep the collateral. The chances of getting the loan are higher.
  • Unsecured — you provide no collateral at all. The Interest rate and fees will be higher, but the amount you can borrow — lower. If your credit history is poor, it will be hard to obtain a loan.

Installment Loan

This one is the most common loan with concrete repayment terms and fixed monthly payments due before the maturity date. Because installment loans are paid off as monthly payments, the debt can be repaid without putting a huge strain on the cash flow. This makes installment loans a viable option for growing companies.

The interest rate for such loans is lower. 

Revolving Loan

It is a flexible financing tool that provides access to an ongoing and repeated line of credit (LOC) that the borrower can use until the limit is reached. After that, you have to repay the money so it can be borrowed again. Typically, financial institutions examine the potential borrower’s financial statements in advance to ensure that the company will be able to repay the debt. 

What you need is a strong credit history. If the company doesn’t meet the lender’s expectations, the financial institution can lower the maximum amount of the loan. 

Cash Flow Loan

This is a short-term unsecured borrowing used for day-to-day operations of a small business. A  financial institution gives you money for your working capital (payments for inventory, payroll, etc.) and expects you to pay it back with the incoming cash flow of the business.

As this loan is not conventional, the credit analysis will be more thorough. Because of potential default risk, the interest rate will be higher. Also, in some cases, the lender will require a blanket lien —  legal interest for a creditor in all of the borrower’s assets serving as collateral. 

The Pros and Cons of Debt Financing

Debt payments are tax-deductibleThe total cost you must pay back exceeds the initial amount
Rapid business growthThe debt must be repaid regardless your financial state
You are the only owner of the companyIt can be risky for small businesses with inconsistent cash flow
A good business credit history for the futureYou will need collateral in most cases
The lender will have no claim to future profitsNegative covenants restrict businesses from pursuing alternative financing options
Debt obligations are predictableAssets are likely to be seized in case of default

In this series, we explore some of the most common types of financing that businesses use. Take a look at the next chapter to find out more.

👉 Learn more about business financing 👈

Nastya Sudilovskaya

Nastya Sudilovskaya

Nastya is a Copywriter and has a Bachelor's degree in Translation and Interpretation and a Diploma in a third foreign language. She has experience in writing articles for small business owners, and in translating psychology educational materials, specifically MBTI personality types. Nastya is dedicated to writing educational articles. She likes gathering new information and is glad to share it with others.

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