The concept of a business establishment borrowing fund advance to be paid back to the lender at any future date with a specific interest is called debt finance. The financing could be in the form of an unsecured or secured loan. A business firm may take up such a loan to raise the working capital, to expand the business, or for acquisition.
In debt finance, debt means the money which is borrowed and needed to be paid back to the lender. Financing means offering funds to render the business activities. The important advantage of debt financing is that the business owners don’t lose their ownership of the company.
Debt financing is a simple, time-bound financial activity in which the borrower is obliged to pay back the loan along with interest at an agreed rate over the specified time period. The frequency of repayment could be weekly, monthly, quarterly, etc. based on the loan tenure and agreed upon terms.
Another key factor to be noted in some sort of debt financing is that the fund advance is collateralized or secured with any assets of the borrower. This process is called secured a loan. If the loan is unsecured; which means the funds are released without guarantee of any collateral, the line of credit may usually be lesser.
If a company is aiming to avail a sizable loan for which debt financing is considered, the business owners usually attach some of the company assets based on its valuation to secure the loan. Say, for example, if a company is looking for a loan of $50,000, then it may raise this capital by selling some or shares of the institutional investors.
However, debt financing may be a bit expensive mode of raising funds for business as the company needs to get an investment banker also involve who will structure these big loans more systematically. This is a viable option in case if the interest rates are low and the return on investment is better. Businesses usually avail debt financing as they don’t have to invest their own capital; however, too much debt will surely be risky.
Using debt financing for business growth
Those who run a small business may be having mixed attitudes towards sustaining a debt for their business fundraising. This is mostly due to the way these debts are portrayed in consumer media. They may come across in news updates like the consumers getting saddled by spending over the credit card limits or the graduates getting weighed down over their student loans etc. However, we can see from the debt consolidation reviews that many of the modern SMEs are now using the avenue of debt financing very effectively to expedite growth and know that borrowing funds responsibly will actually be the most sensible move. Here are some reasons why debt financing becomes more sensible.
1. It is less expensive
Debt financing is more advantageous when considering the cost of debt overtime versus company equities to raise finances. With equity, you have to give up a certain share of a business and also sacrifice its existing and future value of your business to meet a long-term financial need. The final cost of the equity may also be unclear during the time of purchase. This makes the entire process much complex and uneasy to manage.
Compared to this, a financier may also make the actual final cost of the debt clear to you at the first point itself, which makes planning much easier. If the cost is bearable to the business, then you don’t have to surrender the equity vis-à-vis the control of your business, which is very important.
2. Debt financing will aid in revenue growth as it offers a better headroom for working capital
Suppose if you seriously lack in capital to purchase the inventory, and total cost of the goods you sell is $5000, and revenue may be $10,000, will you borrow $5,000 at the cost of $1,000 to actualize an order?
In turn, you may be making a profit of around $4,000. In this, opportunity cost by excluding $1,000 in terms of interest will be $4000. In fact, any business owners may be happy to pay off $1,000 if there is a scope of making a profit of $4,000. This is a simple example whereas real-time finances may be even cheaper compared to this. The rates now start at about 7.2% on APR.
If you can identify the right opportunity to raise funds through debt financing, the debt may be a highly admirable strategic choice, which will let you explore new channels for growth. While assessing the final cost of debt for raising capital or business expansion, consider if the return on investment you make with the aid of that cash advance is higher than the actual cost of debt. If the returns are deemed to be higher than the debt cost, then debt is fully worth.
3. Relief of corporate tax on the interest may also lower the overall cost of a debt
Debt financing may also offer some surprising benefits in terms of tax on business revenue. The actual cost of interest of debt may usually be reduced from the taxable profit so that you may find an overall reduction in the tax bill. Due to this, the actual interest rate on your debt may also be much reduced compared to the actual rate of interest if you calculate this.
At the other end, if you try and raise funds through equities, then you are supposed to shell out your profit to equity holders as dividends, which may not be reflected in any profit tax relief. Business firms which leverage buyout usually use borrowing money over longer terms as an ideal strategy to get better returns. SMEs also can use the same debt financing effectively to fund for growth and enhance their finances.
4. Debt financing will help reduce hoarding cash
Cash hoarding may harm a business’s opportunity to re-invest their profits for add-on returns. This may be very important while you try to grow your business. On hoarding the fund from a peak season anticipating a pinch point in future, then your profits are not actually getting reinvested. However, businesses which want to optimize their growth can surely enjoy the advantage of deploying their surplus cash by adopting debt financing.
In any case, if the debt is well managed and you make repayments on-time and well planned, you can also improve your credit score too along with profits. It will ultimately escalate the spending limit and also cut down interest rates in the future when you look for funds.