Debt financing is a time-bound activity where the borrower needs to repay the loan along with interest at the end of the agreed period. The payments could be made monthly, half yearly, or towards the end of the loan tenure.
Debt financing is an expensive way of raising funds, because the company has to involve an investment banker who will structure big loans in a systematic way. It is a viable option when interest costs are low and the returns are better. A company undergoes debt financing because they don’t have to put their own capital. But too much debt is also risky and thus, companies have to decide a level (debt to equity ratio) which they are comfortable with.
Deciding Factor
- How important is it for you to retain full control of the business?
- How important is it to know precisely what you’ll owe in monthly payments?
- Are you comfortable with making regular monthly payments?
- Are you able to qualify for debt financing? How is your credit history? Do you have a good credit rating?
- Do you have collateral you can use? Are you comfortable with using it?
Advantages of Debt Financing
Maintain Ownership of your Business
You might be tempted to get an angel investor for your growing business. This is definitely a way to infuse cash into it. But, you’ll need to ask yourself if you want outside interference from investors? If you prefer to call the shots for your business, it makes sense to leverage debt financing – in other words, borrowing from a bank or other type of lender and paying it back in the agreed upon timeframe. The bank may charge you interest on what you borrow, but they’re not going to get involved with how you run your day-to-day operations.
Retain Control
When you agree to debt financing from a lending institution, the lender has no say in how you manage your company. You make all the decisions. The business relationship ends once you have repaid the loan in full.
Accessibility
Get the capital you need to grow your business through a relatively straightforward process. When compared to equity financing, debt financing tends to be less complicated because there’s less compliance and you don’t have to go through the process of screening equity partners or the convoluted process of negotiating and coming to an ownership agreement.
Easier Planning
You know well in advance exactly how much principal and interest you will pay back each month. This makes it easier to budget and make financial plans.
Tax Deductions
Surprising to some, taxes are often a key consideration when pondering whether or not to use debt financing for your business. Why? In many cases, the principal and the interest payments on business loans are classified as business expenses. These can be deducted from your business income taxes. In some ways, the government is your partner in your business with a percentage ownership stake (your tax rate).
Ownership and Control
Unlike equity financing, debt financing allows you to retain complete control over your business. You don’t have to answer to investors, therefore there’s less potential for disagreements and conflict. Even if it’s a secured loan, you would give up only on the collateral (and not your business) if you were to default.
Lower Interest Rates
This is a somewhat difficult advantage of debt financing to understand, but it can actually be quite valuable. Tax deductions can affect your overall tax rate. In many cases, there can be a tax advantage to taking on debt. For example, if your bank is charging you 10 percent interest on a business loan, and the government taxes you at a 30 percent tax rate, you can tabulate the following Take 10 percent and multiply it by (1-30 percent), which equals 7 percent. After your tax deductions, you will pay a 7 percent interest rate instead of a 10 percent rate. It’s a win-win financial move that lets you both get the money you need to grow your business while also helping to slash your tax rate.
Organise your Business finances
1. Set up a Business Bank Account
If you operate as a sole trader you don’t legally have to have a separate bank account for your business you can use your personal account. However, to easily track your business income and expenses, consider opening a separate business account.
If your business operates as a partnership, company or trust then you must have a separate business bank account for tax purposes.
2. Set up a Bookkeeping System
There are many manual and electronic bookkeeping products that could suit your business. If you’ve employed a financial professional, have a chat to them about the products that will best work with their systems.
3. Prepare a Budget
Preparing a budget outlining your forecast income and expenses helps you manage your cash flow when starting and running your business.
4. Payment Types and Invoicing Templates
You’ll need to decide on your payment terms and payment types your customers can use. You may also need to set up an invoicing template and receipts to give your customers when selling goods and services.
It’s important to provide a correct invoice for your goods and services. Make sure to include a clear due date and follow up on payments that fall behind. If your business provides subscriptions or memberships, consider setting up an automatic payment system or direct debit. This will save you the hassle of chasing payments.
5. Manage your Cash Flow
Keep track of the money that’s coming in and going out of your business. An easy way to do this is to use a cash flow statement. A cash flow statement allows you to track your income and plan your expenses. This lets you plan ahead and feel comfortable in the knowledge that you’ll have the money to pay your bills.
Pitfalls of Cash Management
Growth Requires Cash
Growth is one of the most common goals of businesses, but it is not without risk. And, it can require a lot of cash. Whatever you think you need in cash, it is likely you may need 50% or even 100% more. For a manufacturer or other B2B company, growth may mean bringing on larger customers, which can be a big boost to revenue. What is not always planned for, however, is the impact of these new customers on your cash conversion cycle. Most likely, that new customer will dictate the terms on which they pay you. That can quickly erode available cash to a business. International growth can have the same effect. Despite the increasing pace at which the world moves, conducting business internationally can mean increased lead time with suppliers and longer delivery times to customers, again stretching the cash conversion cycle.
Plan for the Ups and Downs
Many businesses are seasonal. However, most of those same businesses don’t treat their cash accordingly. Don’t get caught in the trap of celebrating a big month or quarter thinking the business has turned a new page and burn too much cash in the near term. If in retail and Q1 is traditionally slow, stock cash away even after that big holiday season. If the success continues, you will be left with too much cash.
Bank Financing
The worst time to seek bank financing is when you have no other options. Like any deal, you want to approach your bank from a position of strength. That removes risk for them and enables you to achieve much better terms. A good banker exists to help your business, but they can only do so by ensuring they are taking on a manageable risk. Banks love when customers can present them with a plan, and have the ability to look into the future of their business. Carefully evaluating the cash requirements for the business in the next 6, 12, 18 months or more enables you to ask for the right deal and likely ensure adequate liquidity to support that future.
Reserve for Big Outflows
Depending on how predictable cash flow is, for many businesses, large outflows can cause major cash challenges. This can apply to once-a-year expenses, once-a-quarter expenses, capital expenditures, or even payroll weeks. To combat a cash crunch due to timing, you should reserve cash during normal periods or times of surplus. For example, for an annual expense like an insurance premium, reserve a monthly amount so by the time the renewal hits, the cash is available.