The Pros and Cons of Debt Financing You Should Know as a Business Owner

In a perfect world our businesses would always generate enough sales and profit to cover not just the basics such as payroll, rent, inventory, utilities, taxes, and similar, but also enough to increase our customer base and revenue as well. But that’s not always the case; sometimes sales are seasonal, the economy tanks,  customers are slow to pay, or the world gets blind-sided by a global pandemic like COVID-19, that essentially brings the global economy to a halt. In times like these, when cash flow dries up, business owners may not have enough capital to meet the business’ basic obligations. 

In other cases, business may be going well but nonetheless, the cash flow may not be enough to enable the business to reach its expansion or growth goals. In these kinds of situations, when ongoing cash flow isn’t enough to meet the businesses’ current needs, entrepreneurs generally look to outside sources of capital to get the help they need. Enter debt financing, a reliable option for many entrepreneurs and small business owners. 

What is Debt financing? 

According to Investopedia, “Debt financing occurs when a firm raises money for working capital or capital expenditures by selling debt instruments to individuals and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid.”

Sources of Debt Financing

Some of the most common sources of debt financing include: banks; credit unions; family and friends; financing companies; factoring (financing against receivables); lines of credit; credit cards; and borrowing from a retirement account, among others. 

With the recent passage of the COVID-19 pandemic-related $2 trillion Stimulus Package, there are now a wide variety of different types of low-interest or in some cases, forgivable loans, available to small businesses that have been negatively impacted by the COVID-19 crisis. 

There are advantages and disadvantages to debt financing as a means of securing growth capital for your small business. Let’s take a look at some of the pros and cons. 

Pros of Debt Financing

• No complications with business ownership: While getting external investors can help a business meet its short- and long-term capital needs, this type of investment comes with the price of giving up company equity and the prospect of outside interference in how you manage your business. Debt financing will solve this problem because banks or other types of debt lenders generally have no interest in getting in the way of business operations. You just need to pay off the borrowed amount in the agreed timeframe.
• Deductions from business income taxes: When you make your businesses’ principal and interest payments for business loans, they are categorized as business expenses. As such, they typically become deductions from the income tax of the business. It’s a beneficial move in the long run because you can secure the money you need for your entrepreneurial venture while cutting down on your tax rate.

Cons of Debt Financing

• The challenge of payments: When sales are strong and the business can easily cover the monthly debt payment, the risk of taking on debt to finance growth can be worth it. But as with any business, cash flow can be really unpredictable at times. And businesses that aren’t generating enough cash flow to cover the loan payments quickly find themselves in a downward spiral of debt that can be tough to overcome. While some of the new SBA loan programs made available through the various COVID-19 stimulus programs offer very flexible payment terms or in some cases, even loan forgiveness, this is not always the case. 
• Interest rates can be excessively high: Banks and other financial institutions lend money because they earn interest on the loans. This is their compensation for the risk they entered in lending money to you. In some cases, lenders charge very high interest rates that can make the loan difficult to pay off. When interest rates are high and business owners are struggling, they often just make the minimum monthly payment.  When this happens, business owners often get trapped in a years-long cycle of making payments that are almost entirely going towards interest, not the principal. Sadly, this is the business model of many predatory lenders. These lenders specifically seek out business owners desperate for cash and willing to agree to almost anything to get the cash they need. 
• Potential loss of collateral: To protect the lenders, there is also the concept of collateral that will serve as their safety net. Collateral can be real estate, machinery or other types of tangible assets that can be sold off if the business owner defaults on the loan.  

Deciding the Best Course of Action in Debt Financing

Different situations require different decisions. After weighing the pros and cons of debt financing, you need to figure out what is the best fit for your requirements. Before taking on debt to finance business growth, be sure to carefully weigh the pros and cons and make an informed decision. 

If taking on debt can lead to more cash flow and increased profits, then it could be seen as a wise investment. However, if the debt just ends up as a static expense, there may be difficulty trying to pay it off, which could hurt the business’ cash flow even more. 

It is also important to pinpoint what stage the business is in. Debt financing for a new or less-established small business may prove to be fatal as money can be lost before profits come in. Additionally, if the business owner has bad credit or is unlikely to have the discipline to pay back the loan, debt financing may not be the right option. 

In situations like this, business owners should talk to a financial professional to explore other modes of funding such as grants, revenue-based financing or other non-traditional funding instruments.