What Is Debt Financing?
Like individuals, businesses may require financing for a large purchase. If a business needs an expansion but cannot afford to use the company’s existing funds, debt financing — that is, taking out a loan or line of credit which must be repaid — is just one option. This gives the company the freedom to continue operations without monetary strains on daily operations. When a company seeks money through debt financing, they are selling the debt to an investor. There are also different options in how the investor profits. Depending on what type of debt financing the business uses will determine how and when the money is repaid.
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Types of Debt Financing
Common types of debt financing are unsecured and secured loans from private institutions and retail banks. Companies can also sell the debt to investors by issuing bonds, notes, and bills, which are also considered secured debt financing.
When applying for a loan, most lenders will require an application, a credit check, along with other qualifications. This includes documentation to show business performance history and pre-orders (orders placed by clients in production). They may require additional documentation showing other debts (if any) and tax returns. Even with a good credit score and a solid financial picture, the individual or company often will be required to put up collateral for a secured loan.
A secured loan typically involves transactions such as real estate and most automobiles for example. These loans involve the creditor holding collateral to guarantee that if the loan defaults, then there is protection for their investment. Collateral may come in many forms, such as a home, automobile, raw undeveloped real estate, and investment accounts. For a business taking out a secured loan, the collateral can be inventory, invoice collateral, and blanket liens.
A homeowner typically uses the home to secure their mortgage loan. This is the same for an auto loan. Using investment accounts for collateral is for establishing a line of credit based on the market value of the investment account. The lender is typically the investment firm. If market conditions fluctuate and fall, the lender could call the loan early and there may be more funds owed to make up the difference between what you owe and what is left in your account.
Unsecured loans (personal, bank, government-backed) are not typical because the creditor doesn’t have a guarantee for a return on the investment. With an unsecured loan, the risk is higher for the lender and the borrower has a substantial interest rate. Despite there being no collateral on the loan, lenders check credit scores to assess the borrower’s repayment capability.
Sometimes, a creditor may establish a covenant that sets the rules and parameters of the investment. The covenant may be a restriction, however, often a lender may agree to a reduced interest rate for the burden placed on the borrower. There are specific metrics a lender will use in calculating covenants. Not all covenants are negative. For example, some stipulations may be as simple as the borrower maintains the machinery for optimal production. Some may impose limits on gaining other loans or making large purchases during the repayment period.
Lines of Credit
Credit cards are a typical example of lines of credit as are HELOCs (home equity lines of credit). Banks issue credit cards which are another form of an unsecured loan. They issue funds on limited information and no collateral from the borrower. This makes interest rates high. Some credit cards come with annual fees and steep late fees when the payment is missed by even one day.
HELOCs are a line of credit with the house as collateral. This is not a bad thing if you use the funds to make improvements in the home. This is essentially financing an asset. However, if your financial situation is different and you use the funds to pay off any unsecured debt such as credit cards, then that is securing an unsecured debt. If you default on your loan, you risk having to go through a foreclosure.
Investors vs Creditors
Creditors versus investors differ in how they profit from giving money to a business or person. If an investor invests money by purchasing debt in the form of bonds, for example, then the investor will profit from the interest paid on the bonds, twice a year or annually. They are attractive to some investors because they provide a steady stream of income. A creditor (lender) profits from the interest on the loan paid by the terms they set. For example, if a person borrows from a lender for an automobile purchase, then each month the borrower would pay principal and interest.
Nearly anyone can provide the loan, from banks to independent investors to a personal acquaintance. Each of these options presents its own pros and cons. If you are to take out a loan from an acquaintance, it is best to treat it as a regular unsecured loan if you are not putting any collateral for them to collect. If you default on the loan, you risk a fall out with your acquaintance, and potential legal ramifications should the person (s) pursue legal action for your default on the loan. If you do not get your agreement in writing, and there is a misunderstanding of the terms, this could also lead to potential conflict.
By financing your debt by a creditor through a secured loan, your collateral could be in the form of business assets based on valuation. If you default on your loan, the creditor can force you to liquidate the assets to collect on them with the potential of your business failing. A loan can also impact the debt to income ratio and borrowing power dependent on the business’s overall financial picture.
Debt Financing Pros and Cons
The benefit of debt financing is the company can still operate without dipping into funds for other business needs. Any interest is tax-deductible in the year you pay interest, payments have set intervals and with a finite time to pay off the loan. This enables the business to plan expenses around loans.
Dependent on which debt financing is used may come with high-interest rates. If you default on the loan, the creditor may send your account to collections or ask for a judgment for a lien on other assets. Other drawbacks are if the business defaults on the loan, this will impact credit scores and borrowing power for the business and the owners depending on how the loan is titled. Another disadvantage of debt financing through a loan is if the business is seasonal. You must make payments despite non-peak business times.
An individual or business should consider all possibilities of debt financing. The potential outcomes from any debt financing are impacted by market conditions, credit scores, and the financial health of a company or individual.
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This post was updated November 7, 2019. It was originally published November 7, 2019.