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Benefits and Risks of Debt Financing

Debt Financing

When a company needs capital for a major purchase or expansion, it may pay choose to pay cash. In the more likely scenario, however, the company will consider financing options, such as debt.

One common way for companies to finance a purchase is through debt financing, which has many benefits and risks. In debt financing, a company receives a loan that they make a commitment to repay with some conditions, such as set monthly payments and an interest rate.

There are two primary types of debt financing: a secured or unsecured loan. A secured loan is one where the borrower provides something of value to serve as collateral. An example would be a home mortgage. Here, lenders can recoup losses by retaking possession of the property if the loan is not paid back.

With an unsecured loan, the lender does not have any collateral to repossess in the event that the borrower fails to make their payments. As a result, the interest rates are usually higher. A credit card is a prime example of an unsecured loan.

In debt financing, the borrower must repay the borrower he principal and interest. The principal is the amount borrowed, while interest is a percentage added to compensate the lender.

Another type of lending is known as equity lending where the lender receives stock or fractional ownership of the business.

Repayment Terms in Financing

Short-Term LoanTypically less than one year
Intermediate-Term LoanGenerally, have a one to a three-year term
Long-Term LoanA three to twenty-year period may be long term

Keep in mind that these terms for loans are estimated ranges. All lenders recognize that loans involve risk. The term of a loan generally impacts the amount the lender is willing to loan and the amount of interest they will require.

A short-term loan is often for a smaller dollar amount but has a higher rate of interest. A long-term loan may be for a larger amount and have a lower rate of interest.

Despite having a potentially lower interest rate, a long-term loan accrues interest over a significantly longer period. A long-term loan is more commonly used to fund large capital purchases for an organization.

Types of Debt Financing

When borrowing from an institution like a bank, it is relatively easy to compare conditions from different lenders. Debt financing does not always involve a traditional lender such as a bank, however. Some start-up companies or small businesses may seek to borrow from friends, family, or other private sources. In these less formal arrangements, the parties should put the agreement in writing.

A bond involves a loan from an individual investor to a company that has a definite term and interest rate. One variation of a bond is a debenture. A debenture is an “unsecured loan certificate” that is based on the credit history or trustworthiness of the borrower.

Benefits of Debt Financing

There are a host of benefits of debt financing. For one, the borrower still maintains full ownership of the business, unlike other arrangements that allow lenders to obtain leadership positions and influence decision-making.

Debt financing inherently reinforces the temporary nature of the relationship between the borrower and lender. Once the debt has been repaid according to the contract, the relationship concludes.

A major benefit is the predictability associated with debt financing. The provisions of the loan clearly define the term of the loan and the interest rate. This makes it easy for the borrower to accurately forecast and manage this aspect of their cash flow. Additionally, interest paid on this type of loan is usually tax-deductible.

Risks of Debt Financing   

For borrowers, one of the main drawbacks is that lenders are likely to have some eligibility requirements. The lender may require a borrower to have a strong credit history, which means many startup companies are unlikely to obtain approval.

While it can be an advantage, the fixed payment schedule of debt financing can be challenging for a company with inconsistent cash flow. Another disadvantage of debt financing is that failing to make a loan payment by a specific date will almost always result in late fees and penalties.

The lender may require that a borrower — especially a startup with minimal credit — to provide collateral in order to qualify for a loan. But those same new businesses may not have acquired any assets that are sufficient to satisfy the requirements of the lender. The borrower may find themselves using personal assets as collateral, which often exposes their families to risk.

Common Types of Collateral

  • Real estate: Property is a common form of collateral. Real estate, often with a house or building included, is generally seen as among the most stable types of assets, as long as the owner has sufficient equity. 
  • Inventory: Tangible items owned by the company may be used as collateral. Lenders are likely to only lend a percentage of what the total stated value of inventory is.
  • Accounts receivable: This involves invoices that have been issued that are awaiting payment.

Collateral vs Securities       

Collateral is typically a tangible asset, such as a home or vehicle. On the other hand, security is something of value that exists in financial markets, such as bonds or stocks. The lender assumes control of the security during the loan period.

Lenders generally view securities as a riskier option because the value of securities could potentially plummet.

An organization’s credit rating or history is often a major consideration in potential financing agreements. On one hand, a borrower with a minimal credit history and no debt may be considered as healthy. More commonly, the lender would view the company’s insufficient track record of borrowing money and repaying those obligations as a red flag.

Lenders often will consider the ratio of a company’s existing debt compared to income or equity. Companies with significant debt relative to their cash or assets may be considered as “highly leveraged” based on its equity ratio. 

Provider of Alternative Solutions for Growth Capital  

Revtek Capital is an established lender that offers business owners revenue-based financing that supports their growth. Based in Arizona, we partner with dynamic technology companies in various industries seeking working capital. For more information, we invite you to visit our site or contact our office at (480) 332-0399.

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