Debt Financing: The Definitive Guide for Small Businesses

Is debt financing right for your small business? Get a handle on how it works, different types and pros/cons.
Jan 29, 2021

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One of the two main ways that a business can finance its operations, debt financing is the process in which a business borrows money to fund working capital, the purchase of specific assets or other operations. This money is to be paid back at a future date, with interest.

Debt financing stands in contrast to equity financing, in which business owners sell equity, or ownership, in their business in exchange for capital.

How does debt financing work? And, is a small business loan right for your needs?

In this guide, we'll break down everything there is to know about debt financing so that you understand all of your options and have all the information you need to decide what's best for your business.

How debt financing works

As we'll see below, debt financing can come in many forms—but most generally, there are three overarching structures:

  • Business term loans: In this case, you borrow a set amount of money from a lender, receive a lump sum upfront and pay the money back, with interest, for the term of the loan. These loans usually have a set, fixed payment schedule. These loans may be secured or unsecured—they may also be referred to as traditional term loans or installment loans.

  • Line of credit: With a line of credit or a revolving loan, you have access to a set credit line that you can pull from and use as needed. Unlike a term loan, you only pay interest on the funds you use and once you've repaid what you've borrowed, your credit line resets.

  • Cash flow loans: With cash flow loans, you receive an advance of funds based on the revenue you're earning. Then, instead of paying back money over time, with interest, you receive the remaining percentage of your revenue, minus the lender's fees, as your cash flow comes in. Invoice financing and merchant cash advances both could be considered cash flow loans.

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Debt financing examples

Based on the above structures, all of the following would be considered examples of debt financing:

  • Loans from family and friends.

  • Bank loans.

  • Personal loans.

  • Government-backed loans, such as SBA loans.

  • Lines of credit.

  • Credit cards.

  • Equipment loans.

  • Real estate loans.

Long-term vs. short-term debt financing

Another important point to distinguish here is the difference between long-term vs. short-term debt financing. Although there is some variation, in most cases, short-term debt financing refers to any financing with a repayment period of one year or less, whereas long-term debt financing refers to financing with a repayment period of a year or more.

Short-term financing is used to cover more immediate, day-to-day, working capital needs, as well as emergencies. Long-term financing, on the other hand, is better suited for larger projects like buying a business, renovations, equipment purchases, real estate investments, etc.

Sources and types of debt financing

Overall, there are a variety of sources that a business can turn to for debt financing, including:

  • Banks and credit unions.

  • Online, alternative lenders.

  • Nonprofit lenders.

  • Merchant cash advance companies.

  • Friends and relatives.

Plus, each of these sources—particularly banks and online lenders—can offer different types of debt financing, depending on what your business needs and of course, what you can actually qualify for. With this in mind, let's break down some of the most common types of debt financing:

SBA loans

The Small Business Administration (SBA) is a federal agency dedicated to helping entrepreneurs improve their small businesses, take advantage of contracting opportunities and gain access to business funding.

Keep in mind that the SBA does not directly loan money to businesses. Still, the agency’s various loan programs increase the chances that small businesses will be approved for loans by guaranteeing all or part of the loans. These guarantees provide a bigger incentive for lenders to approve loans for small businesses by easing their anxieties.

There are three main SBA loan programs that help a wide variety of small businesses obtain debt financing:

  • 7(a) program: The most common SBA loan program, the 7(a) loan program offers loans up to $5 million to be used for a wide variety of purposes. Use our guide to learn more about the SBA 7(a) loan program.

  • Microloan program: The SBA microloan program provides financing opportunities for entrepreneurs in need of between $500 and $50,000 in funding. Designed for newer businesses, the SBA microloan program is one of the best forms of debt financing for startups. Learn more about the SBA microloan program.

  • CDC/504 program: The SBA’s CDC/504 loan program is designed for businesses looking to make a major fixed asset purchase—such as large equipment, land improvements, or the purchase or renovation of an existing building. Borrowers through this program can take out up to $5 million, with repayment terms of up to 20 years and interest rates based on current treasury rates. Use our guide to learn more about the SBA 504 loan program.

Term loans

As we described in detail above, a traditional business term loan is the easiest type of debt financing to understand, because it’s probably what you naturally think of when you think of a business loan. You borrow a fixed amount of money, usually for a specifically stated business purpose. Then, you pay back the loan over a fixed term and typically at a fixed interest rate.

If you’re looking for a loan with a fixed interest rate and predictable monthly payments that can be used for a wide range of business purposes, a term loan will likely be your first and most obvious choice.

Business line of credit

business line of credit is perhaps the most flexible form of business funding available. A line of credit gives you capital to draw upon to meet a variety of business needs.

Once established, you may draw on your line of credit as you would a personal credit card. You can use this capital for whatever your business needs—to buy inventory, handle seasonal cash flows, pay off other debts, or address almost any other business need.

Plus, you only pay interest on the funds you draw and in most cases, lines of credit are revolving—once you've paid back what you've borrowed, your credit line resets to the original limit.

Equipment financing

Applying for equipment financing can be a quick, streamlined way to access funds to purchase computers, machinery, vehicles, or virtually any other equipment for your business.

Similar to a car loan, the equipment itself acts as collateral for the loan. Because of this, you’re more likely to be approved without offering separate collateral than you would with other types of debt financing.

Invoice financing

If delayed payments from clients are endangering your cash flow, invoice financing is a great option to get your receivables back on track.

Through this process, you’ll get a fast advance of about 80% of the value of your invoices. Then, you’ll receive most of the additional 20% you’re owed later on, minus the fees the financing company charges you to work with them.

Merchant cash advance

A merchant cash advance, or MCA, is a lump sum payment of liquid capital. An MCA company will offer it to a business in exchange for a percentage of the company’s future sales. When you receive cash from a merchant capital provider, you agree to pay back the cash advance, plus a fee, by allowing the provider to automatically deduct an agreed-upon percentage of your company’s daily credit and debit card sales.

The downside to a merchant cash advance is expense and payment frequency. The daily deductions from your business's sales can significantly eat into your cash flow—plus, when it comes down to it, this is one of the most expensive types of debt financing on the market.

Advantages and disadvantages of debt financing

Now that you have a better sense of how debt financing works and what your options are, let's discuss the pros and cons of funding your business this way.

Advantages of debt financing

  • You maintain control of your business: The main advantage of debt financing—compared to equity financing—is that you maintain complete control of your business. A lender is helping you fund your business, but they have no say in day-to-day operations. With equity financing, on the other hand, your investor becomes a co-owner of the business. This means that they may want some say in the direction of the business, given that they stand to make or lose money depending on how the business performs.

  • You can receive tax deductions: Another benefit of debt financing is that the interest payments you pay are tax-deductible. This deduction is available to all types of business owners, including sole proprietors, partnerships and S-corporations. In addition, many of the costs of financing a loan, such as origination fees, are also tax-deductible. These tax advantages could also stand to lower your interest rate.

  • Easier to access compared to equity or other forms of financing: Finally, debt financing is simply easier to acquire than equity financing or more creative forms of financing, like small business grants. Typically, equity financing is reserved for young, high-growth businesses that project to bring in a high amount of revenue very quickly—think of companies like Uber or Airbnb. Grants, on the other hand, are highly competitive, feature lengthy application processes and tend to be pretty specific about what you can spend the money on.

  • Variety of options: With debt financing, as we've seen, you have a variety of types to choose from—including term loans, lines of credit, invoice financing and more—from a variety of sources. It's very likely that you'll be able to find a type of debt financing that meets your business needs.

  • Builds business credit: One of the biggest advantages of debt financing is that if you maintain a good payment history, you'll build business credit and improve your business credit score. This will be essential as you grow your business's financial profile and will only increase your chances of being able to qualify for other types of debt financing in the future.

Disadvantages of debt financing

  • Risking business or personal assets: The main disadvantage of debt financing is obvious: If you can't pay back the loan, your business assets are at risk. If you don't have sufficient business collateral, the lender might also require you to sign a personal guarantee. This means that the borrower is personally responsible for paying back the loan. Therefore if your business hits a rough patch and you end up defaulting on your loan, the lender can seize your house, personal savings and more.

  • Can impact cash flow: Depending on the terms of your loan, you may also find it difficult to grow your business while making monthly payments on your loan. Furthermore, if you have a loan with a variable interest rate, the amount you end up owing month to month could fluctuate, which could have an impact on your cash flow.

  • Can be difficult to qualify: Although usually easier to access in comparison to equity financing, it can be much more difficult to get debt financing if you're a startup founder seeking funding for a business idea or if you have bad credit.

How to choose the right debt financing for your business

Now that we’ve reviewed all the different debt financing options—as well as the possible advantages and disadvantages—how do you decide which one is right for you?

Ultimately, this decision depends on a number of factors that will vary from business to business. Here are the five main factors you’ll want to consider:

  • Amount of financing you need. The size of your loan will depend on what you can afford—but if you don't have a realistic plan to repay your financing, you shouldn't obtain a loan in the first place. Create a realistic budget for your business for the length of your desired loan and then come up with a number that meets your needs.

  • Use of funds. As you may have noticed above, the different types of loans suit different spending purposes. If you’re purchasing equipment, for example, you might consider an equipment loan.

  • Nature of your business. If you have a seasonal business, that may change the type of financing that works best for your needs. Seasonal businesses can sometimes have trouble making consistent daily, weekly, or monthly payments, since their sales volumes aren’t consistent from month to month. That’s why seasonal business owners might consider an alternative form of financing without a set payment schedule, such as a business line of credit.

  • Affordability of financing. Which loan option can you afford? Depending on your business circumstances, it may be that your ideal loan amount doesn’t match with your ability to qualify or with the loan amount you can afford.

  • Ability to qualify. Of course, it would be ideal to shop around and choose the perfect debt financing option with the perfect interest rate. But the reality is that your options may be limited by your ability to qualify. Therefore, before you start any applications, you'll want to take a look at the most common business loan requirements and find out where your business stands and what you're likely to qualify for.

The bottom line

At the end of the day, most business owners will turn to debt financing at one time or another as a source of funding for their operations. Luckily, from SBA loans to lines of credit, there are a variety of types of debt financing from which to choose.

This article originally appeared on Fundera, a subsidiary of NerdWallet.