Debt Financing: The Complete Guide to Follow to Secure the Loan

Running a business means a constant requirement for capital to expand and grow. For every business, whether it’s a startup or a large enterprise, there are several ways to raise money, and the most common one is debt financing. 

So, what is debt financing? In simpler terms, a company borrows money and agrees to repay it on time, along with interest. In this blog, we’ll learn why debt financing is the best choice for entrepreneurs and how it differs from other types of financing. 

What is Debt Financing?

Financing is a method through which companies raise funds, and in the case of debt financing, they utilize debt instruments to get the money. They go to an external financing source, such as a bank or venture capital firm, and repay the money over time with interest. 

This is one of the safest approaches followed by startups and big companies alike to raise immediate funds for operations and expansions without compromising on the ownership. 

This is simply what debt financing meaning, let’s go ahead and see how this actually works. 

How Does Debt Financing Work?

Debt finance acts as a loan for a company, and the process of getting the funds through it is pretty straightforward. The business fills out the papers with its revenue and other company details and applies for the loan with the collateral, if any. In addition, the lender checks the business’s background and creditworthiness by evaluating cash flow, fixed costs, profits, debts, and the company’s market reputation. 

Once everything is checked and clear, the business receives the funds and gets the authority to use them for growth, purchasing equipment, or bridging working capital gaps. Then the repayment period starts upon the agreed monthly or quarterly terms, along with the added interest on the sum.  

The interest and entire repayment period will vary from business to business. Plus, there may be a requirement for collateral in case of new startups. 

Types of Debt Financing

Debt financing is available in several forms, and no one-size-fits-all solution works for the various types of companies. Here are the common types of debt financing you must know about:

• Term Loan: In this, the companies need to pay lump-sum loans over a predetermined duration with fixed or adjustable interest rates. This one’s commonly utilized by mid-sized firms for capital investments or business growth.

• Line of Credit: The companies can take loans using their line of accumulated credit, and pay back flexibly. This option’s best for managing the company’s workflow efficiently.  

• Equipment Financing: This financing is solely for purchasing equipment and machinery for the operations of the company. Here, the equipment itself acts as collateral for the loan. 

• Merchant Cash Advances: A big sum is given in return for a share of upcoming sales. This is ideal for companies with significant credit card transaction amounts.

• Bonds: The large companies can issue bonds to gather capital from individuals or organizations. Bondholders receive interest payments and get repaid when the bond matures. 

Check Out: Retained Earnings: Explanation, Formula, and Importance for Businesses

Debt Finance: Advantages and Disadvantages 

Debt financing is a smart way for a company to get funds without giving away the company’s shares; however, like every financing instrument, you must know about its benefits and even the trade-offs. Here’s the list of pros and cons of debt financing that can help you design your growth strategy and finances accordingly. 

Advantages:	Disadvantages:
Business owners get to keep the entire equity with complete control over the operations.	Loan interests can be hefty and burdensome, especially for small-scale businesses.
You can get tax benefits where interest payments can be deducted from the taxes.	The repayment commitment can be difficult to follow during the troubled financial health of the company.
The repayment period is set every month on a particular date, which makes financial planning easy.	Debt financing holds great power over the credit impact. Meaning, any missed payment can harm your credit rating directly.
With regular payments to cover the loan, you can build a great business profile and boost your credit line.

Debt or Equity Financing – Which One’s Better?

Every business comes to a point where it has to decide how it should raise money. It can be done either by taking a loan or bringing in an investor by giving away the equity. Well, both debt and equity financing have their positives and negatives, have different working mechanisms, but serve the same purpose of raising funds. 

Here’s the well-presented difference between debt and equity financing:

Aspects	Equity Financing	Debt Financing
Ownership or share	The percentage of ownership needs to be given away.	The complete ownership remains with the business owners.
Repayment Strategy	Does not require repayments; the investor’s profits are through business growth.	Requires repayments in fixed instalments along with an interest rate.
Cost	Share of profit.	Interest payment.
Risk Associated	Lower risks but with diluted control.	Higher risks based on hefty repayment amounts.
Best For	High-growth startups that need money and industry advice.	Best for short-term needs to manage the cash flow.

Taking into consideration the above aspects, you can easily differentiate between debt or equity financing and see which will work best for your requirements.

Tips for Securing Debt Financing 

Getting approved for debt financing is not an easy deal, as it requires you to prove that your business is perfectly capable is returning the owed money with interest. However, preparation is the best way to go when applying for bank loans, credit loans, or through any other source. Here are a few tips and tricks to get you started!

• Build a Strong Credit Profile: From day 1 of starting the business, make sure to build a separate credit profile and make regular payments to maintain it. Lenders check the business’s credit scores during the approval process. 

• Prepare Financial Statements: Always maindtain and keep a track of your balance sheets, accounting equations, income statements, and cash flow projections. The lenders like to check the history of the record along with the current financial position. 

• Lay Out a Clear Business Plan: Having a strong business plan with solid foundations can help you raise money easily based on the idea and the work. Plus, it outlines how much money you need, the purpose, and the expected ROI. 

• Understand the Loan Agreement: Any type of loan can turn into a financial burden if the terms and conditions are not clear. Make sure to check multiple options, review interest rates, understand hidden fees, and the repayment model of debt financing. 

• Lower Your Debt-to-Income Ratio: If you possess several loans or high expenses relative to your income, lenders might be reluctant. It is important that you maintain a manageable debt-to-income ratio to appear more trustworthy to lenders.

Having a well-prepared loan application with all the backing and records will significantly increase your chances of receiving funds through debt financing. 

Wrapping Up!

Debt finance is a widely used option that fits all types and sizes of businesses. It allows you to have the desired amount of money you require for the business operations while keeping the entire ownership. Debt financing can also offer tax accounting benefits and help maintain decision-making power. 

Just before accessing a loan through this medium, make sure to evaluate the company’s status, financial health, and growth plans. We have explained plenty about debt financing definition and how debt and equity financing are different in providing flexibility and support to a business.

Read Next: Payslips Explained: Components, Importance, and Everything You Must Know About

Frequently Asked Questions 

Sources
How Debt Financing Is Adapting To Compete With Equity Financing: Forbes