Merits And Demerits Of Debt Financing

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Today, there are several options by which people can get funding support for their business. They can approach some angel investors, accelerators, VC firms, startup incubators, and many other sources. All of them, partially or entirely, come from the line of seed capital investors. People who are not able to secure any help from these funding sources could still go for a few options. One such alternative is debt financing. In this process, you borrow money instead of staking investors for future benefits. There exist some merits and demerits of debt financing. Today, we will have a look at both of them.

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What Is Debt Financing

Before getting to know about debt financing, it is crucial to understand what it actually is. Debt financing is a particular way of funding your startup by borrowing money. In this process, you secure a loan for your business. You do this by selling bills, bonds, and notes to individuals or an investors group. With this, the individuals or an investment group act as your business creditors. In return for offering money, they take the principal amount and interest on their debts. Now, there exist two types of debt financing; short-term debt financing and long-term debt financing. We will talk about them below. 

1. Short-Term Debt Financing

This type of debt financing is used to raise money for day-to-day business operations. These operations could be supplies, purchasing inventory, wages or additional expenses, etc. In debt financing for the short term, money is to be repaid within a year. Few examples that belong to this financing are lines of credit, accounts payable, lease payments, and wages.

2. Long-Term Debt Financing

In long-term debt financing, money is raised for the assets your company will purchase. These assets could range from building or land to equipment or machinery for your business. In debt financing for the long term, money is to be repaid within eight to ten years. Mortgage loans, term loans, and bonds are some of the examples of this type of debt financing. Now let’s go through the advantages and disadvantages of debt financing. 

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Merits And Demerits Of Debt Financing

1. Merits of Debt Financing

A primary advantage that debt financing has over other financing methods is your lender has no ownership in your company. The lender has no authority over your business. He or she is just expecting the interest on the loan borrowed by you. In the event of long-term debt financing, monthly expenses are lessened because the time of repayment could be extended up to many years. Besides this, there are other advantages which are as follows. 

  1. Debt financing is able to offer support for the equity of the business owner.
  2. Debt financing allows owners to build up credit for their businesses. 
  3. Debt financing saves your time for future planning. 
  4. Debt financing is known to bring stability to your budgeting.
  5. Long-term debt investment could reduce dependency on short-term alternatives.

2. Demerits of Debt Financing

In debt financing, a bank is the most sought place to secure a loan. Banks generally ask business people to post their business assets as security for the loan in case of long-term debt financing. If the business failed to provide enough assets as the collateral, banks could ask entrepreneurs for personal guarantees. These personal guarantees could be up to 20 percent of income from the company. If your assets lacked price enough for securing a loan, then chances are that you will not get the loan. Even if your company is consolidated, only you will be liable to compensate for the borrowing. In the worst scenario of not repaying for a loan, banks could seize your personal assets. Besides this, there are several other disadvantages of raising money through debt financing. Some of them are:

  1. Debt financing always follows a high cost and a fixed monthly payment plan. You cannot ask for some reduction in that plan. This proves to be one of the greatest obstacles in the growth of your business. 
  2. You should always have a strong business plan so that banks could show some confidence while giving a loan. Your business plan should include all the budgetary details like projections of cash flows, income statement and balance sheets. If you failed to provide any one of them, chances are you will end up taking nothing to your home. 

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Final Thoughts

In this guide, we learned about debt financing and the merits and demerits of debt financing. There are several platforms that provide funding for new startup companies. For their financial needs, people can go either for equity-based sources or debt-based sources. Both of these methods have their own merits and demerits. You can choose debt financing if you want to free yourself from any sort of ownership in the business. A percentage of entrepreneurs still go for it due to this reason. Finally, you should always know that a strong business plan could convince anyone in providing money.