When starting a business, there are three ways to get the money needed to help that business run: personal financing, equity financing, or debt financing. Debt financing requires the business to take out a line of credit or a loan in order to meet financial obligations under a structured system of returning the money at some point. There are some advantages and disadvantages to consider when borrowing money, so here are some key points to think about.
What Are the Pros of Debt Financing?
1. There is no need to sacrifice a portion of the ownership rights to the business.
Debt financing keeps everything under personal control. Equity financing, on the other hand, requires a company to cede a portion of the ownership to the investor(s) that are providing the financing. Although the debt requires structured payments to be made that can sometimes be bothersome or difficult to meet, the ownership group behind the business still has 100% equity.
2. The fees and interest on the debt may be tax deductible.
It is possible to deduct the costs of business debt as an actual business expense. Sometimes even the principal amount can also be classified as a business expense. The end result is a lower income tax liability that can actually save a company money every year because of the presence of debt. This means an interest rate on the debt taken out could wind up being close to zero after all is said and done.
3. It provides immediate cash without reporting responsibilities.
Unless a line of credit is taken out for a specific reason, such as a building loan for the creation of a new asset, there are generally no stipulations on how the cash from debt financing can be used. When there are other forms of financing involved, there can be numerous decision-makers that must be consulted or reporting responsibilities to gain spending approval that can be quite time consuming.
4. Once the debt is paid, there is no longer an obligation.
Debt financing eventually disappears, even if it is a long-term debt that has been taken out. With regular monthly payments, the budget improves every month over time as the principal gets paid down, helping the business to grow as their overall debt responsibility shrinks.
What Are the Cons of Debt Financing?
1. The money from debt financing has to be paid back.
Although soliciting money through investors can be difficult or problematic, it does raise funds that don’t have to be paid back. Debt financing, on the other hand, requires payments no matter how much revenue may be coming into the business. You’re always held responsible to this debt, even in a Chapter 11 bankruptcy that allows the debt to be restructured, which means it is an obligation that will always be there.
2. Interest rates could be very high.
Debt financing could cost a lot to make happen. Interest rates are based on risk, not on need. If a business has poor credit or the ownership group running the business has a poor history of repaying their obligations, then the interest rates could be extremely high and not beneficial to the needs of the company. Every application may also negatively impact the credit of the business.
3. There is no guarantee of approval.
A lender doesn’t have to extend debt to a business even if the credit for that business is perfect. There are no guarantees that debt financing will come through. Putting all of one’s financial chips into this basket could be a mistake that takes a business toward bankruptcy instead of viability.
4. Debt financing naturally reduces the available amount of cash liquidity.
A business doesn’t perform the same way every year, every month, or even every day. There are plenty of variables that can create a reduced income flow during some periods, but an increased income flow during others. Debt financing doesn’t care about this. It requires a structured payment and when sales are low, this affects the cash liquidity of the business to a point where it could be extremely harmful.
The pros and cons of debt financing must be carefully considered before a final decision is made. In essence, taking on debt is essentially a gamble. It can be a very safe gamble, but taking on any debt carries with it some level of risk. By understanding these key points, it becomes easier to know if this is the right method of cash infusion for you.
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