Debt Financing: Definition and Examples

Lauren Ward

Updated May 20, 2021

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Debt financing can be an effective resource for getting your small business the capital it needs. There are countless structures and loan terms to explore, but what your company is eligible for will depend on your business model, financials, and timeline for funding. Find out everything you need to know about debt financing to give your business an infusion of capital.

What Is Debt Financing?

Debt financing is essentially borrowing money for your business from an external source. In exchange for the borrowed funds, you agree to pay back both the principal and interest, as well as other fees in some cases (like an origination fee). Debt financing can take many different forms, from traditional bank loans to merchant cash advances of invoice financing.

How Does Debt Financing Work?

Debt financing can be structured in many different ways. You can apply for short-term or long-term options. Short-term debt financing is usually used for operational expenses, like buying inventory or covering payroll during slow seasons. These loans typically need to be paid off within a year. While all types of businesses may opt for short-term financing, newer businesses with less established credit and revenue may be more likely to qualify for these loans than if they applied for long-term financing, for which lenders may require businesses to have a longer track record. Short-term loans are also likely to come with higher interest rates.Long-term debt financing is likely to be used for large purchases, like equipment or real estate. You might also opt for long-term debt financing when expanding your business. Generally the term to pay off these loans is a year or longer. For higher loan amounts, the longer payoff period can make the payments more affordable, and these loans tend to have lower interest rates than shorter-term financing. However, you typically need to be an established business with strong revenue in order to qualify for long-term financing.

Pros and Cons of Debt Financing

All financing decisions involve both advantages and disadvantages. Consider the impact debt financing could have on your small business before making any decisions.

Pros of Debt Financing

One of the biggest benefits of debt financing is that you get to retain ownership of your company. By way of contrast, one alternative to debt financing is equity financing, which doesn’t require you to make repayments on the funds you receive, but does require that you sell shares of your company in exchange for that capital. That means that instead of making loan payments for a set period of time, you’ll always have to share your profits with your investors. That’s why debt financing is often more attractive to small business owners — the financial obligation is temporary. Another advantage of debt financing is that the payments you make on principal and interest may qualify as business tax deductions. It can also potentially lower your tax rate by reducing the amount of taxable income. Finally, debt financing builds a history of business credit--a good one, as long as you keep up with your payments. This sets you up for even more financing options in the future, potentially with better terms.

Cons of Debt Financing

Debt financing comes with some drawbacks as well. Periods of slow cash flow can make it difficult to keep up with payments. On top of that, interest rates may be quite high, making it a potentially expensive form of financing. It’s important to weigh the pros and cons of the cost of the financing, since paying for it will eat into your profit margins. Will the benefits to your business outweigh the price? Another downside is that you may need to use business assets or a personal guarantee (or both) to secure the loan. In that case, if you default on the loan, any assets that were used to secure it could be repossessed by the lender. You could also face a personal lawsuit and lose your savings and home, depending on the terms of the personal guarantee. These are significant risks to take, so it’s important to understand the terms of your debt financing and feel confident in your ability to repay the borrowed funds.

Debt Financing Examples

There are many types of business loans that are examples of debt financing. Here are some common options to consider.

Traditional Loans

A traditional loan is typically issued by a financial institution like a bank or credit union. You then make regular payments, which include principal and interest, to repay the loan over a fixed period of time. These are long-term business loans that allow you to borrow larger amounts for bigger capital projects. The loan application process for these loans may have stricter requirements than other kinds of loan demand, like a minimum amount of time in business, proof of revenue, and a strong credit history.One of the benefits of a traditional business loan is that your payments are predictable, making it easier to plan your financial obligations. You may also receive better loan terms, including a lower interest rate. On the downside, the approval process can be lengthier than ones for other options.

Online Loans

Online business loans may be better suited for less established small businesses and those seeking access to quick funds. Loan terms may vary depending on the lender, but applications are typically vetted almost instantaneously and, if approved, you could get your funds within a single business day. Some online lenders also cater specifically to startups or businesses with no credit history. Of course, these loan products tend to come with higher interest rates, but may still be worth it. Another advantage of choosing an online loan is that you can compare multiple business loans through Lantern Credit to quickly find the best offer available.

SBA Loans

SBA loans usually offer favorable terms for borrowers, but there are some strict eligibility criteria you must meet for this type of debt financing. For the SBA 7(a) loan, you can borrow up to $5 million for five to 25 years. But you need to meet the SBA’s size standards, demonstrate that you’ll be able to repay the loan, and have exhausted all other financing options. An SBA loan also requires a down payment and a personal guarantee. Like a traditional business loan application, an SBA loan application asks for multiple financial statements, including profit and loss statements for the last three years, year-end balance sheets, reconciliation of net worth, and more. The approval process also takes longer for SBA loans than it does for some other types of loans.

Short-term Business Loans

Short-term business loan terms typically last for 12 months or less, though in some cases they may extend to as much as 18 months. Common uses for this type of debt financing include working capital, inventory purchases, cash flow, marketing, expansions or improvements, and covering unexpected costs. Short-term business loans are often offered by online lenders, which means you can expect some of the same benefits (and drawbacks). Advantages include easier approval and faster funding times, while the main disadvantage is that these loans can be costly.In addition to loans, short-term debt financing can also include financing like the following:

Each of these options comes with its own set of pros and cons to evaluate before applying.

Business Line of Credit

A business line of credit is a type of revolving credit that allows you to borrow money as you need it, up to the limit of your credit line. As you repay the borrowed funds, you can generally continue to draw on the line. You pay interest on only your outstanding balance, making it a convenient type of debt financing for smoothing out cash flow or covering small expenses that you’ll repay fairly quickly. Eligibility requirements typically include credit score (both business and personal), revenue, personal investment, and collateral. To apply, you’ll need to supply documents like bank statements, financial statements, tax returns, and proof of collateral (if you’re taking out a secured line of credit).

Should You Choose Debt Financing for Your Small Business?

Deciding on debt financing is a big decision that can impact the future of your business, for better or worse. Putting too much strain on your cash flow with hefty payments can hurt your company and its growth potential. But not taking advantage of new capital can also stymie your business’s growth. As you contemplate the pros and cons, consider not only what you stand to gain, but also any likelihood of a worst-case scenario happening.Here are some situation in which you might give some serious thought to debt financing:

Your company is in its early stages. If your business is young, you likely won’t have access to equity financing. Not only that, you probably wouldn’t want to give away a large chunk of equity early in your business’s lifespan. Instead, consider ways to bootstrap or qualify for debt financing that make sense in your industry.

You have temporary cash flow issues. Debt financing can be a useful tool in getting over short-term hurdles. This is especially true if your business is seasonal or has a temporary issue that you feel confident will resolve itself soon.

You don’t need to borrow a lot. If you don’t need a huge investment, different debt financing structures can help you obtain a smaller amount of financing. That way you’re paying interest only on funds you actually need.

You need capital quickly. There are various forms of debt financing that get funds in a business bank account much faster than equity financing or most other alternatives. Focus on online options if you’re truly strapped for time.

Alternatives to Debt Financing

Most of the kinds of financing you may think of for providing funds for your business--including credit cards and personal loans--fall under the heading of debt financing. There is another kind of funding, however, known as equity financing.In equity financing, a business gets capital from investors. In return, the business sells them shares (equity) in the company. This means that the investors own a percentage of the company. The business doesn’t pay back the funds, but it will have to pay dividends to the investors.Equity financing has its own set of pros and cons. It can be a good way for a new business to get an infusion of cash and potentially good advice from experienced business people. However, equity financing can also be difficult and time-consuming to get, and it means that the business owners are relinquishing some of the control of the business to others.

The Takeaway

If debt financing sounds appealing to you, remember that the options vary widely. Focusing on the debt financing opportunities that are structured to meet your specific needs is a good idea. So is avoiding applying to lenders that don’t make sense for your industry or business plan. To help you find the most appropriate options, consider using Lantern Credit to compare offers from multiple lenders with just one questionnaire. Find out what’s available today.

This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice. SOLC21007

About the Author

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.

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