Before we look at the pros and cons of debt financing, we will firstly establish what it is and look at a few examples.
Debt financing is one of the traditional ways in which most businesses are funded. Debt is also referred to as leverage in finance. This option involves borrowing money to be paid back plus interest incurred over a set period of time.
Debt is normally not a problem but how you manage it may become a problem. Debt financing has a lot of advantages but also has disadvantages which mainly arise from poor management.
Banks are the major sources of debt financing, however today we also have private companies in the game.
Debt Financing includes options like;
- SBA loans.
- Short term loans.
- Equipment financing.
- Business line of credit.
- Personal loans.
…and many others.
Let’s now look into the pros and cons of debt financing.
Pros of Debt financing.
You have full control of your business.
Unlike other forms of business financing like equity financing, you retain full control of your own business. You don’t have to give up part of your business or share the profits as it is done with other investors.
It gives you an opportunity to grow your trust.
Trust is important when you are running a business, especially with the people that have the money. If you are good at paying your debts, you will be able to build trust which means you could have money whenever you most need it.
Creates tax deductions.
In most cases, the principal and interest payments on a business loan are classified as business expenses, and they can, therefore, be deducted from your business’s income at tax time.
Cons of Debt Financing
- Re-payment starts the first month. In most cases, especially for the case of startups, you haven’t made your first dollar yet! Worst thing is; you will continue to make those re-payments even when your business is failing.
- It could impact on your credit rating. When you borrow money, the risk in the eyes of the other lenders goes up which means that you will pay high interest rates for the other loans that you might attain before fully paying off your current loan.
- Some lenders may require you to put up collateral which puts your own assets at risk.
- The application process can sometimes be too long. In some cases you will need to write a business plan and provide a lot of documentation. Aside this, you also need to have a good credit rating. This can be rather frustrating if you are a start-up or have suffered financial difficulties before.