Pros and Cons of Debt Financing

If you are a small business owner, it is likely that you will run into the need for some extra cash to purchase inventory, hire staff, or buy an expensive piece of equipment that will streamline your processes.

Debt financing is the technical term for borrowing money from an outside source with the promise to return the principal plus a percentage. There are many types of debt financing that are available to small business owners including micro loans, business loans, credit cards, and peer-to-peer loans.

There are many pros and cons of debt financing that needs to be considered before taking funds from an outside source. They need to be weighed carefully and it is important to remember that what is good for one person might not be a good idea for another.

Although debt has negative connotation attached to it, there are some pros to debt financing which are below.

The Pros of Debt Financing

  • Maintain ownership of your business – if you prefer to make the decisions in your business, it makes sense to leverage debt financing. Borrowing from a bank or other lender and paying it back upon a timeframe. The bank might charge you interest on what you can borrow but will not get involved in the day-to-day operations.
  • Tax deductions – taxes are a key consideration when pondering whether or not to use debt financing. The principal and the interest payments on business loans are classified as business expenses. These can be deducted from your business income taxes. In some ways, the government is your partner in your business with a percentage ownership stake.
  • Lower interest rates – this is a difficult advantage of debt financing to understand but it is quite valuable. Tax deductions can affect your overall tax rate. There are advantages to taking on debt.

The Cons of Debt Financing

  • Paying back the debt – making payments to a bank or other lender can be stress-free if you have ample revenue flowing into your business. If sales are down or if your business fails, you will still be on the hook for the debt.
  • High interest rates – do not expect to get low interest rates from a traditional bank or other lender. Interest rates vary on a variety of factors including your credit history and the type of loan you are trying to obtain. Even after calculating the discounted interest rate from your tax deductions you might still be paying a high interest rate each month that cuts into your profits.
  • Your Credit Rating – what you borrow affects your credit rating and it can be a negative effect if you are borrowing large sums. This translates into higher interest rates and more risk for the lenders.
  • Cash flow difficulties – lenders expect payment on debt financing in equal monthly installments. It can be real challenge that can lead to late payments or even defaults that can harm your credit over the long term. If you know you are not going to pay back the loan, do not get one.

When You Should Use Debt Financing

To determine if this is the right move for your business, ask yourself the following questions:

  • Will you invest in variable or fixed costs? - When you invest in fixed costs such as office furniture or a piece of equipment, you will not see direct cash returns from the funds you have borrowed. This can be a risky option for debt financing when you consider that your installment payments on the loan will begin soon after the money is lent.
  • At what stage is your business in? – debt financing in the early stages of your business can be dangerous. Almost all businesses lose money before they start turning a profit. And, if you can’t make payments on a loan, it can hurt your business credit rating for the long-term. Remember that bankruptcy is highest in the first few years of a business and then it decreases the longer you are operating.
  • Do your customers pay on time? – pay attention to the payment habits of your customers and that they pay on time.
  • Are you organized enough to make regular payments? - explore other types of financing if you have a bad habit of forgetting to make payments.