One of the two main ways that a business can finance its operations, debt financing is the process in which a business borrows money to fund working capital, the purchase of specific assets, or other operations. This money is to be paid back at a future date, with interest.
Debt financing stands in contrast to equity financing, in which business owners sell equity, or ownership, in their business in exchange for capital.
How does debt financing work? And, is a small business loan right for your needs?
In this guide, we’ll break down everything there is to know about debt financing so that you understand all of your options and have all the information you need to decide what’s best for your business.
As we’ll see below, debt financing can come in many forms—but most generally, there are three overarching structures:
Based on the above structures, all of the following would be considered examples of debt financing:
Another important point to distinguish here is the difference between long-term vs. short-term debt financing. Although there is some variation, in most cases, short-term debt financing refers to any financing with a repayment period of one year or less, whereas long-term debt financing refers to financing with a repayment period of a year or more.
Short-term financing is used to cover more immediate, day-to-day, working capital needs, as well as emergencies. Long-term financing, on the other hand, is better suited for larger projects like buying a business, renovations, equipment purchases, real estate investments, etc.
Overall, there are a variety of sources that a business can turn to for debt financing, including:
Plus, each of these sources—particularly banks and online lenders—can offer different types of debt financing, depending on what your business needs, and of course, what you can actually qualify for. With this in mind, let’s break down some of the most common types of debt financing:
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:
As we described in detail above, a traditional business 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. 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.
A business line of credit is perhaps the most flexible form of business funding available. A 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.
Plus, you only pay interest on the funds you draw and in most cases, lines of credit are revolving—once you’ve paid back what you’ve borrowed, your credit line resets to the original limit.
Applying for equipment financing 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 you would with other types of debt financing.
If delayed payments from clients are endangering your cash flow, invoice financing is a great option to get your receivables back on track.
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, minus the fees the financing company charges you to work with them.
A merchant cash advance, or MCA, is a lump sum payment of liquid capital. An MCA company will offer it to a business in exchange for a percentage of the company’s future sales. When you receives cash from a merchant capital provider, you agrees to pay back the cash advance, plus a fee, by allowing the provider to automatically deduct an agreed-upon percentage of your 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’s sales can significantly eat into your cash flow—plus, when it comes down to it, this is one of the most expensive types of debt financing on the market.
Now that you have a better sense of how debt financing works and what your options are, let’s discuss the pros and cons of funding your business this way.
Now that we’ve reviewed all the different debt financing options—as well as the possible advantages and disadvantages—how do you decide which one is right for you?
Ultimately, this decision depends on a number of factors that will vary from business to business. Here are the five main factors you’ll want to consider:
At the end of the day, most business owners will turn to debt financing at one time or another as a source of funding for their operations.
Luckily, from SBA loans to lines of credit, there are a variety of types of debt financing to choose from. Therefore, if you think you’re ready to continue your search for debt financing, you can check out our comprehensive step-by-step guide on how to get a business loan.
Meredith Wood is the founding editor of the Fundera Ledger and a vice president at Fundera.
Meredith launched the Fundera Ledger in 2014. She has specialized in financial advice for small business owners for almost a decade. Meredith is frequently sought out for her expertise in small business lending and financial management.