Debt Financing Definition
Debt financing is any type of business loan that a company uses to fund working capital, the purchase of specific assets, or other operations. Based on the type of loan you are seeking, debt financing can be either long term or short term. With all debt financing the borrower must pay back principal and interest on the debt. If the borrower defaults on the loan, they typically have to forfeit some form of collateral to repay the debt. This is in contrast to equity financing, where business owners sell equity in their business in exchange for capital.
If you’re researching options to fund your small business, a term you have likely come across is debt financing. If you’re new to the world of small business lending, researching debt financing can feel like entering a foreign country. There are terms you don’t know and concepts you’ve never heard of. Plus, you might be asked to sign documents and make decisions based on information you don’t totally understand. The options when it comes to debt financing are seemingly endless, and there are so many pros and cons to each. How do you know which way to turn?
If debt financing is among the options you’re considering, you’ll want to master its ins and outs before making the decision. Let this guide help you understand the complete process of shopping and applying for a small business loan.
What Is Debt Financing?
Debt financing is financing a business with a loan. It occurs when a business receives money from a lender to be used for working capital or capital expenditures in exchange for an obligation to repay the lender the principal of the loan plus interest.
Debt financing includes both secured and unsecured loans. Security is typically a form of collateral that will be forfeited if the borrower defaults on the loan. Collateral could include real estate, inventory, unpaid invoices, cash, or a blanket lien on your business. Short-term debt financing is designed to provide a business with working capital, whereas long-term debt financing is used for the acquisition and maintenance of fixed assets, such as property or equipment.
How Debt Financing Works
Debt financing goes way beyond traditional business loans from a bank. It includes a wide variety of different loan products that businesses can choose from to access funding. What these products have in common is that they all involve some sort of repayment terms. This means that your business—and in many cases you, as the owner—is held liable for that repayment.
Debt Financing Examples
All of the following are examples of debt financing:
- Loans from family and friends
- Bank loans
- Personal loans
- Government-backed loans, such as SBA loans
- Lines of credit
- Credit cards
- Real estate loans
Debt financing covers a lot of ground, but there are other ways to fund your business. Small business grants and venture capital funding, for example, are alternatives to debt financing (more on these later). Let’s explore in detail the differences between the various types of debt financing products.
6 Types of Debt Financing
Your options for debt financing extend far beyond the traditional bank loan. As the alternative lending market has grown, so too have the types of debt financing available to small businesses. Here are the various loan products you may consider for your business financing needs:
1. SBA Loans
The Small Business Administration (SBA) is a federal agency dedicated to helping entrepreneurs improve their small businesses, take advantage of contracting opportunities, and gain access to business funding.
Keep in mind that the SBA does not directly loan money to businesses. Still, the agency’s various loan programs increase the chances that small businesses will be approved for loans by guaranteeing all or part of the loans. These guarantees provide a bigger incentive for lenders to approve loans for small businesses by easing their anxieties.
There are three main SBA loan programs which help a wide variety of small businesses obtain debt financing:
7(a) Loan Program
The 7(a) loan program is the most common of the SBA’s various programs. As it should be—it offers the most open-ended terms and qualifications, making it suited for a wide variety of businesses. Through this program, borrowers can access up to $5 million in funds for working capital, equipment and real estate purchases, basic startup costs, or even debt refinancing.
Qualification is left to the discretion of intermediary lenders. They’ll also determine the interest rates and total cost of the loan. However, the backing of the SBA often makes lenders more likely to approve term loans through this program than they otherwise would.
Many solopreneurs and micro-entrepreneurs struggle with access to debt financing. This is because the loan sizes they typically need don’t meet most lenders’ lower limits. To address this challenge, the SBA created the microloan program. SBA microloans provide funding opportunities for entrepreneurs in need of between $500 and $50,000 in funding. The average microloan amount is about $14,000.
These loans are designed for businesses who have never before received a bank loan and have low or nonexistent business credit history. As with the 7(a) loans, exact rates and eligibility standards are guided by the SBA. However, they’re ultimately left to the discretion of the intermediary lender.
CDC/504 Loan Program
The SBA’s CDC/504 loan program is designed for businesses looking to make a major fixed asset purchase—such as large equipment, land improvements, or the purchase or renovation of an existing building. Borrowers through this program can take out up to $5 million, with repayment terms of up to 20 years and interest rates based on current treasury rates.
Keep in mind, though, that these are the most highly regulated of all SBA loans. Typically only well-established small businesses with long and strong credit histories will be able to qualify.
2. Term Loans
A traditional term loan is the easiest type of debt financing to understand, because it’s probably what you naturally think of when you think of a business loan. The terms are pretty simple. You borrow a fixed amount of money, usually for a specifically stated business purpose. Then, you pay back the loan over a fixed term and typically at a fixed interest rate.
If you’re looking for a loan with a fixed interest rate and predictable monthly payments that can be used for a wide range of business purposes, a term loan will likely be your first and most obvious choice.
3. Business Line of Credit
Next we have what is perhaps the most flexible form of business funding available. A business line of credit gives you capital to draw upon to meet a variety of business needs. Once established, you may draw on your line of credit as you would a personal credit card. You can use this capital for whatever your business needs—to buy inventory, handle seasonal cash flows, pay off other debts, or address almost any other business need.
4. Equipment Financing
Applying for an equipment loan can be a quick, streamlined way to access funds to purchase computers, machinery, vehicles, or virtually any other equipment for your business. Similar to a car loan, the equipment itself acts as collateral for the loan. Because of this, you’re more likely to be approved without offering separate collateral than with other types of debt financing.
5. Invoice Financing
If delayed payments from clients are seriously endangering your cash flow, invoice financing is a great option to get your receivables back on track. Also known as accounts receivable financing, invoice financing is a system in which companies buy your accounts receivable.
Through this process, you’ll get a fast advance of about 80% of the value of your invoices. Then, you’ll receive most of the additional 20% you’re owed later on, proportional to the amount of your invoices that were actually repaid.
6. Merchant Cash Advance
A merchant cash advance is a lump sum payment of liquid capital. A lender will offer it to a business in exchange for a percentage of the company’s future sales. When a borrower receives cash from a merchant capital provider, he agrees to pay back the cash advance, plus a fee, by allowing the provider to automatically deduct an agreed-upon percentage of his company’s daily credit and debit card sales.
The downside to a merchant cash advance is expense and payment frequency. The daily deductions from your business sales can significantly eat into your cash flow. However, in addition to being fast and easy to qualify for, a merchant cash advance can be a great fit for seasonal businesses that might struggle to make regular daily, weekly, or monthly payments during their slower sales months. If you don’t have any sales on a particular day, the merchant cash advance company will wait until the next day that you bring in revenue to deduct your payment.
Debt Financing: Choosing the Best Option for Your Business
Now that we’ve reviewed all the different debt financing options, how do you decide which one is right for you? Ultimately, this decision depends on a number of factors which will vary from business to business. Here are the five main factors you’ll want to consider:
1. Amount of Financing You Need
The size of your loan may need to derive from the size of loan you can afford—but if you don’t have the capital you need to achieve your goals, there’s no point in obtaining financing at all! Create a realistic budget for your business for the length of your desired loan, and then come up with a number that meets your needs.
2. Use of Funds
As you may have noticed above, the different types of loans suit different spending purposes. If you’re purchasing equipment, for example, you might consider an equipment loan.
3. Nature of Your Business
If you have a seasonal business, that may change the type of financing that works best for your needs. Seasonal businesses can sometimes have trouble making consistent daily, weekly, or monthly payments, since their sales volumes aren’t consistent from month to month. That’s why seasonal business owners might consider an alternative form of financing without a set payment schedule, such as a business line of credit or a merchant cash advance.
4. Affordability of Financing
Which loan option can you afford? Depending on your business circumstances, it may be that your ideal loan amount doesn’t match with your ability to qualify or with the loan amount you can afford. Use our debt service ratio calculator to determine the size of loan your business can reasonably take on. Then, you can see if you’re able to align your business goals into steps that are possible with that amount of funding.
5. Ability to Qualify
Of course, it would be ideal to shop around and choose the perfect debt financing option with the perfect interest rate. But the reality is that your options may be limited by your ability to qualify. Later on, we’ll discuss qualification standards like your time in business, annual revenue, average bank balance, and personal credit score. All of these stats will determine exactly which lenders and loan products you’ll be eligible for.
Debt Financing: Advantages and Disadvantages
Relative to other financing options, there are distinct advantages and disadvantages to funding your business using debt financing. Let’s take a look at both:
Debt Financing Advantages
The main advantage of debt financing relative to equity financing is that you maintain complete control of your business. A lender is helping you fund your business, but they have no say in day-to-day operations. With equity financing, on the other hand, your investor becomes a co-owner of the business. This means that they may want some say in the direction of the business, given that they stand to make or lose money depending on how the business performs.
Another benefit of debt financing is that the interest payments you pay are tax deductible. This deduction is available to all types of business owners, including sole proprietors, partnerships, and S-corporations. In addition, many of the costs of financing a loan, such as origination fees, are also tax deductible. These tax advantages could also stand to lower your interest rate.
Finally, debt financing is simply easier to acquire than equity financing or a small business grant. Typically, equity financing is reserved for young, high-growth businesses that project to bring in a high amount of revenue very quickly. Think of companies like Uber or Airbnb.
Small business grants are perhaps more desirable than debt or equity financing because they are essentially “free money.” However, these grants are highly competitive, feature lengthy application processes, are tend to be pretty specific about what you can spend the money on. Furthermore, small business grants are typically reserved for select groups, such as minorities, veterans, or businesses in the science or health fields.
Debt financing, on the other hand, is a funding options available to businesses of all shapes on sizes.
Debt Financing Disadvantages
The main disadvantage of debt financing is obvious: If you can’t pay back the loan, your business assets are at risk. If you don’t have sufficient business collateral, the lender might also require you to sign a personal guarantee. This means that the borrower is personally responsible for paying back the loan. Therefore if your business hits a rough patch and you end up defaulting on your loan, the lender can seize your house, personal savings, and more.
Depending on the terms of your loan, you may also find it difficult to grow your business while making monthly payments on your loan. Furthermore, if you have a loan with a variable interest rate, the amount you end up owing month-to-month could fluctuate, which could have an impact on your cash flow. Applying for large sums of debt financing can also have a negative impact on your credit rating.
How to Apply for Debt Financing
Once you’ve determined which type of debt financing to pursue, it’s finally time to apply for your loan product. The complexity and length of the application process varies widely depending on your lender and loan product. However, all lending applications are designed to answer the same question: Will you be able to repay your business loan?
Answering that question to the satisfaction of your lender can require a lot of documentation. So the more organized you are beforehand, the easier it will be to complete your loan application.
Of course, business loan requirements are different for every debt financing product. However, gathering as many of these documents as possible beforehand will make your life much easier when the time comes to actually complete your loan application.
Documents to Prove Your Business Is Legitimate
First, you’ll need to assure the lender of the legitimacy of your business. Here are a few documents you’ll want to have on hand to prove that your business is real, and that you have the authority to apply for a loan in the business’s name:
- Business License – To obtain a loan, your business needs to meet all federal, state, and local licensing requirements. In addition to basic business registration, your business may also require other industry-specific licensing.
- Proof of Business Ownership – Only the owner of a business has the authority to apply for a business loan, so you’ll need to prove that you own your business. If your business has multiple owners, you’ll need your partner’s written permission to apply for a business loan.
- Franchise Agreement – If your business is a franchise, you’ll need a copy of the FFA agreement you signed with the franchisor.
- Business Plan – While not always required, having a solid business plan shows debt financing companies that you are serious about your business, and that you have a vision and blueprint for your business’s future.
Documents to Prove You Have a Customer Base
In order to make money and pay back your loan, your business needs a solid customer base. Especially if you run an invoice-based service business, gather these documents for use in your loan application:
- Customer List – Who are your customers? A list with names, addresses, contacts, total amount invoiced, and any other database information you have is very helpful. Any reputable lender will never contact your customers without your explicit permission.
- Accounts Receivables Aging Statement – Invoice-based businesses rely heavily on their receivables to maintain good cash flow. Provide your most recent AR aging statement. This document will show how quickly your customers pay you as evidence of your business’s cash flow.
- Credit Card Processing Statements – If you operate a retail business, your credit card processing statements will serve as concrete proof of yours sales volume. Gather your processing statements for the last three-six months as evidence of your sales.
Documents to Prove the Financial Health of Your Business
Your business’s assets, liabilities, revenue, and cash flow paint a picture of the overall health of your business. Your business’s overall health, in turn, shows your ability to make payments on debt financing. Lenders will have questions about both your personal and business finances, which you can answer with the following documents:
- Personal Tax Return – Especially if you have a relatively new business, lenders may ask to see your most recent personal tax return.
- Business Tax Returns – If you’ve been in business for awhile, have your last 2-3 years’ business tax returns on hand to show your long-term revenue history.
- Balance Sheets – Most commercial loan brokers recommend having accurate balance sheets on hand, both for your business’ year to date operations, and for the two prior fiscal years. If you use accounting software like Quickbooks, you should be able to pull your balance sheets easily. Alternatively, you can use our free balance sheet template to create your own.
- Profit & Loss Statements – This shows your company’s revenue and expenses. Include both a year-to-date P&L, updated within the last 60 days, and total profit and loss statements for the last two years.
- Sales Forecast – Particularly if you have a newer business or your most recent profit and loss statements are less than stellar, providing a well-researched sales forecast may help to tip the scales in your favor.
- Business Banking Statements – Provide at least four months’ worth of banking statements, six if you have them, and 12 if your business is seasonal. For each month, remember to include all pages of the bank statements, not just the first.
Disclose Your Other Business Debts
Finally, you’ll need to disclose to the debt financing company any other outstanding debts that your business is responsible for. In addition to other business loans, this may include rent payments on your retail or office space, or payments on business credit cards.
Gather these documents as evidence of your business’s other debts or liabilities:
- Most Recent Accounts Payable Statement – Your accounts payable statement breaks down the accounts payable section of your balance sheet into even more information about who and how much you owe. If you use Quickbooks, you can pull accounts payable reports under Vendors & Payable Reports. Otherwise, you can create an excel spreadsheet similar to your AR aging report.
- Business Debt Schedule – A business debt schedule shows all of your company’s outstanding loan and credit amounts and monthly payments. If you don’t already have one, use our business debt schedule template to create a payment schedule for your business.
Qualifying for Debt Financing
Ultimately, the point of compiling and submitting all these documents to lenders is to paint a picture of your business showing that you meet the lender’s qualification standards for debt financing.
The exact standards used are wide-ranging and can vary from lender to lender. That being said, they typically boil down to these four most essential factors:
1. Annual Revenue
How much money does your business bring in per year, on average?
Lenders like to see that you have enough cash coming into your business to cover your loan payments. Not to mention, they want to make sure you’re able to cover the rest of your company’s operating expenses. That’s why your annual revenue is a major indicator to lenders of your eligibility for a business loan.
Typically, lenders want to limit your total loan amount to less than 12% of your business’s total revenue, ensuring that you’ll be able to make your loan payments even when unexpected expenses come up.
2. Time in Business
How long has your business been operational?
Small business startup loans are notoriously hard to secure. The younger your business is, the less able you are to show a track record and convince the lender that you will be able to repay the loan.
Businesses that have been operational for more than two years are typically considered the most fundable. If you’ve made it through your first year of business, you likely still have options. But if you’ve been in business for less than a year, you might have a harder time qualifying for debt financing.
3. Average Bank Balance
How much cash do you have in your business bank account?
It’s inevitable in business that unexpected expenses come up. From a leaky roof to a bad batch of inventory, these little extra costs can tank your business if you’re sitting unprepared. That’s why even if your sales numbers are fantastic, a low bank balance will raise eyebrows over your ability to cover your loan payments on time, every time.
For maximum fundability, aim for an average bank balance equal to at least three months of operating expenses for your business, including your loan payment. If that feels out of reach, anything over $1,000 will help your loan eligibility.
4. Personal Credit Score
What’s your personal credit score?
Particularly if you’re a first time business owner with a relatively new business, your personal credit score will play a critical role in your chances of qualifying for a small business loan.
Borrowers with a credit score above 700 are typically excellent loan candidates. If your credit score is between 640-700, you’ll likely still have several options available, depending on your credentials in the other three categories. However, if your personal credit score is under 600, you may struggle to qualify for a loan.
The Final Step: Submitting Your Loan Application
The process of researching loan products and compiling paperwork is an arduous one, to be sure. But the good news is that if you’ve already done all that leg work. Actually completing your application should be a breeze!
Contact your specific lender to obtain information about the application and submission process. Then fill out any remaining forms, do your lucky rain dance, and submit!
We hope this guide has answered most of your questions about what debt financing is, how the various types of business loan products function, and how debt financing might work for your business. But if you do have any specific questions about your business’s financial situation, remember that you can always contact a Fundera lending specialist for more information. We’re here to help!