Debt financing involves the funding of investments or commercial ventures with money that has been borrowed from an external source. Exactly what the cash is used for depends on the borrower, but it is often used to fund investment portfolios, start-up companies or the expansion plans of existing companies. In the majority of instances, the borrower will need to provide collateral for the loan, and the principal sum – along with the agreed rate of interest – will need to be repaid in instalments.
But what are the advantages associated with such a financial arrangement? And are there any reasons to be cautious when committing the future of your business or investment portfolio to a long-term loan?
The Pros of Debt Financing
Stay in Control: You can retain full ownership of your business without the need to give away an equity stake in return for capital.
Keep All Your Profits: This form of financing does not require you to commit any of your future earnings to the lender, so you get to keep 100 percent of your profits.
A Limited Commitment: This type of loan always has a fixed term, after which you are free and clear of obligations. Once you have repaid the finance in full, your company is no longer beholding to a third party.
Tax Deductible: The interest you pay on finance is tax-deductible, which can help to limit your business’ total tax liabilities.
Allows More Accurate Financial Planning: Unlike other ways of raising finance, this method gives you a clear picture of what your financial commitments are for the duration of the loan, so you can budget your financial affairs more accurately.
Simple Administration: Whereas the paperwork involved in administering equity financing arrangements can be complex, financing through debt is usually simple. Instead of issuing shares, paying dividends and dealing with various stakeholders, your only commitment is to make the monthly repayments.
The Cons of Debt Financing
Higher Costs: Compared to other ways of raising finance, taking on debt will raise the break-even point of your business.
Collateral is usually required: Creditors will usually insist on some form of collateral as security for your loan, which may require you to risk personal assets of your own.
Regular Repayments: Whether or not your commercial venture makes a profit, the repayments on your debt will need to be made regardless. This is in stark contrast to equity financing, which only requires repayments when your company shows a profit.
Inflexible: This method of financing does not allow any wriggle room should your company experience financial difficulties, however short they are. You will be required to repay exactly the same amount to your creditors every month, which could squeeze the cash-flow of your business.
Various Contractual Restrictions: Financing your business with debt can restrict many of the commercial decisions you want to make while the loan remains unpaid. For instance, you may not be allowed to search for alternative financing when you still owe money to your original creditor.
Depending on the nature of your commercial venture or investment, acquiring debt has both advantages and disadvantages. But consulting with financial experts and weighing up all the options available should enable you to choose the best course of action for your specific circumstances.