What is debt financing and how does it work?

Borrowing money is as old as business itself. Today, debt financing is a common way for businesses to access capital by borrowing money through loans, overdrafts, credit lines, or other external sources of finance. Unlike equity financing, you as the owner retain full ownership – but you’re also on the hook to repay the debt, regardless of business performance. 

Using debt financing strategically requires cash flow management, attention to business credit and an eye on future revenue. In this article, we’ll examine how it works and how to make the most of your financial options.

What is debt financing and how does it work?

Debt financing is the process of borrowing a sum – known as the principal – from an external provider, which is then repaid over time. The finance can come in many forms, including small business loans, merchant cash advances, business credit cards or even a bank overdraft.

In a typical debt financing arrangement, your business will approach a lender with an application to borrow a certain amount of money. You’ll provide the lender with details of your business and how you intend to use the money from the loan. 

The lender will run a number of checks to ensure that you’re ​​creditworthy and have a decent credit profile. If the lender is happy that you’re a low-risk borrower, they’ll propose the conditions of the loan or line of credit. 

This will usually include:

• The amount that you want to borrow
• The terms of the loan and when it will be repaid
• The interest rate you’ll be charged on the loan
• How much the repayments will be and when you’ll pay them
• Any additional conditions like penalties for early repayment of the loan

Types of debt financing options available to businesses

The basic debt financing model is used for many different types of business finance, including short-term business loans, bank overdrafts, asset-based loans and invoice finance that’s used to plug urgent gaps in your cash flow.

Let’s take a more detailed look at some of the most common types of debt financing that you’re likely to come across as a small business owner. 

• Term loan: With a business term loan, you borrow an agreed amount of money and repay it over a fixed period (the ‘term’) with regular, predetermined instalments, Typically, you’ll pay interest on the loan. These types of loan are often used to purchase equipment, fund expansion or finance projects. 
• Asset-based loans: When you take out an asset-based loan, the money you borrow is secured against a specific company asset, like your accounts receivable, inventory or equipment. The loan amount of this secured loan is usually tied directly to the value of these assets, providing capital that fluctuates with the asset base and offering more flexible working capital. 
• Bank overdrafts: With a bank overdraft, you agree to a pre-approved credit facility with your bank, allowing you to withdraw more money than is currently available in your bank account. Overdrafts are designed for short-term working capital needs, giving you the financial flexibility to cover temporary cash flow gaps, with interest usually charged only on the overdrawn amount.
• Invoice finance: Invoice financing helps you access funds by borrowing against your outstanding invoices (the company’s accounts receivable). A lender provides a percentage of the invoice value upfront, and the business repays the loan when customers pay their invoices. It improves immediate cash flow, particularly for businesses with long payment terms.
• Lines of credit – Credit comes in many forms, including trade credit agreements with your suppliers, or applying for a business credit card with your bank. All forms of credit allow you to make purchases ‘on credit’, paying back the amount at a pre-agreed time, usually monthly, with interest added. 

Some less common, but equally useful, types of debt financing include:

• Bonds: A bond is a debt instrument where an investor lends money to an entity (the ‘issuer’). As the issuer, you promise to pay the bondholder regular interest payments over a set period and repay the original principal amount at maturity. Bonds are typically used by larger entities, but some growing small businesses might issue private bonds to raise capital from specific investors
• Venture debt: Taking on venture debt provides capital to your business once you’ve already secured equity funding or venture capital. The loan can be used to bridge funding rounds, extend your cash runway or finance specific growth initiatives, usually with warrants attached. Venture debt helps you avoid taking on more equity funding and the loss of control that can come with that.
• Convertible debt: Convertible debt is a loan that can be converted into equity (ownership shares) in the business at a future date, usually during a subsequent equity funding round. If you’re a startup, it offers a quick and simple way to finance the business, and can be attractive to investors who are looking for a potential equity upside without immediate dilution.
• Structured financing: If you take on structured financing, what you get is a customised loan package that’s tailored to your exact needs and assets as a small business. It combines various financial instruments or repayment terms, and offers real flexibility, but with potentially greater complexity in the terms.

Debt financing vs equity financing: how to choose

When looking for funding for the next stage of your business journey, you’ll generally be faced with two principal routes to funding: debt financing and equity financing.

But which type of financing is best suited for your current business goals?

Debt Financing 

With debt financing, the funds you borrow must be repaid with interest, typically within a set timeframe. Lenders have no ownership stake in your business, but they do expect you to repay the loan on time, regardless of your current business profitability. This creates a fixed financial obligation.

Equity Financing 

When you enter into an equity financing agreement, the funds you receive are exchanged for ownership shares in the business. As such, your investors become part-owners in the business and will take a share in any profits you make. There's generally no obligation to repay the initial capital, unlike debt financing, but equity financing does mean diluting your existing ownership of the company.

How to choose the right financing 

Whether you opt for debt financing, equity financing, or a mix of both, comes down to a number of factors. Your decision will be driven by the specific business goals you’ve set out for the business, the stage you’re at in the business journey and your potential tolerance to both risk and the dilution of your ownership of the company.

• Debt financing is better when you want to keep full control of the business and have the financial performance to pay back the debt incurred when you sign up for a business loan, or a bank overdraft, for example.
• Equity financing is better when you need the combination of private investment in the business and the knowledge and business networks of a group of experienced investors – where you don’t mind seeding some control of the company to your new investors.

What’s the main difference between debt and equity financing?

Debt financing maintains your ownership and control of the company, but does mean taking on the responsibility of debt in the business.

Equity financing doesn’t land the company with any long-term debt, but does mean you handing over some control of the business to your investors. 

‍Advantages and disadvantages of debt financing

Opting for debt financing has a number of key advantages over equity financing. But there are also some downsides if you opt to take on debt in the business. 

Let’s look at the pros and cons of entering into a debt financing arrangement, so you can make the most informed decisions about whether debt is the right route for you.

Advantages of debt financing 

Taking out a business loan is an incredibly common way to fund the next stage in the evolution of your business. But why is debt financing seen as such a positive option for cash-strapped small businesses?

With debt financing:

• You retain full ownership of the business and don’t reduce the control you have over the future path of the company.
• You have a pre-agreed and highly predictable repayment structure, meaning you can factor repayment of the debt into your cash flow strategy.
• The interest you pay on your loan can be tax deductible, allowing you to reduce the overall cost of accessing funding and taking on this debt. 

Disadvantages of debt financing 

On the flipside, there are negative outcomes of debt financing to factor into your decision-making process.

If you take on debt:

• You must repay the full loan amount, regardless of whether the business is turning a profit. It’s a financial obligation that exists until the loan is repaid.
• Loan repayments can eat into your cash flow, putting a strain on your overall cash position if your income and outgoings are not well managed.
• It’s vital to balance the risks and rewards of debt, so you don’t take on more debt than you can afford, while still accessing the funding you need to take your next step or finance your ambitious business goals. 

How debt financing affects cash flow and credit

Balancing your cash flow position is an integral part of good financial management. When you take on debt in the business, the regular repayments you make to your lender must be balanced with stable and predictable revenue generation. 

In other words, to have regular payments going out to your lender, you need equally regular, predictable sales and revenue coming in from your customers. 

Keeping your financial health and credit profile under control 

Once you take on debt, it’s crucial to manage your repayments so you don’t default on the loan. Delinquent payments and failure to repay your existing debts will have a negative impact on your credit profile as a business. And you’ll only be able to borrow more funds with a good business credit score behind you. 

It’s advisable to use financial forecasting tools to understand your cash flow position, cash runway and any potential cash gaps that could become a problem.

Before taking on any debt, and especially once you have debt on the balance sheet, make sure to check that you can afford the debt and the subsequent repayments. 

How much debt is too much for a small business?

In an ideal world, your debt level should be kept as low as possible. One way to check if you’re taking on too much debt is to calculate your Debt Service Coverage Ratio (DSCR). 

DSCR measures your business's ability to generate enough operating income to cover your debt payments. A higher DSCR indicates a stronger capacity to meet debt obligations. A DSCR below 1.25 signals too much debt, as your business lacks earnings to comfortably meet its repayment obligations.

Is debt financing cheaper than equity in the long run?

Debt is generally considered a cheaper route to funding than going the venture capital or private equity route. While you do have to pay interest on a loan, for example, the expected return for a lender is usually lower than that for a high risk investor.

With a business loan, for example, you can claim back the tax deductible interest payments on your loan. You also have the predictable nature of fixed repayment terms, meaning that the cost won’t increase significantly.

There are long-term implications of opting for debt financing. When deciding whether debt or equity is the right funding channel, it’s vital to consider the importance of retained ownership versus the repayment obligations you enter into with a loan. 

For high-growth startups, where investment and the support of experienced investors are a major bonus, equity finance can be a better option than entering into debt. 

How to qualify for and manage debt financing as a small business

When applying for debt finance, it’s essential for lenders to view your business as a low-risk borrower – an enterprise that can meet the conditions of the loan.

Lenders will want to be confident in the future performance of the business and your ability to meet the repayments agreed in the terms of the loan. 

Lenders will look for:

• Creditworthiness: Lenders want to see a healthy credit profile that demonstrates your financial health and your ability to make payments and service an existing debt. 
• Business performance: Lenders also want to be certain of your viability as an enterprise. This is often based on your ongoing business performance, revenue generation, forecasted cash flow and projected profitability.
• Collateral and assets: When applying for a secured loan, lenders will also take into account the value of the assets you hold in the business. These assets may be needed as collateral in the event that you default on the loan repayments.

A major part of appearing credit worthy is being in complete control of your financial management as a business. This means being on top of your cash flow management and budgeting, so you’re in a cash position to meet the repayments.

Lenders will be keen to see financial data and evidence of your successful business performance. A straightforward way to do this is to use cloud accounting software to track, record and measure your financial performance. 

Platforms like Xero, QuickBooks or Sage will allow you to produce balance sheets, profit and loss (P&L) reports and detailed budgets for your operational spending.

Is debt financing a good idea for a startup?

As a general rule, debt financing is not a good funding strategy for an early stage or pre-revenue startup. 

By taking on a business loan, you start your journey with significant debt on your balance sheet, at a point where you either have no revenue streams at all, or have highly unpredictable income. This makes it difficult to repay your debt.

Debt financing with a business loan

Debt financing becomes more practical once you have a defined customer base, regular sales and predictable revenues coming into the business.

This stable revenue and improved cash flow position gives you the financial strength to take on debt and effectively meet the repayment schedule. 

Responsible use of debt financing can help to fund your growth, invest in new projects or cover unexpected cash-flow gaps.

Short-term business loans, like an iwoca Flexi-Loan, bring much-needed extra capital in the business, helping you to extend your cash runway, hire in new employees or open up a new branch as part of your growth strategy. 

These specialist business loans get you the funds you need fast, with flexible terms that are tailored to the unique needs of a growing small business.

iwoca: flexible loans to accelerate your business

If you’re looking for debt finance without the complexity of high-street lenders, iwoca can help. And applying for an iwoca Flexi-Loan couldn’t be simpler. 

Apply on line, provide your business information and have the funds in your bank account in less than 24 hours.

With a Flexi-Loan, you:

• Borrow from £1,000 to £1 million
• Repay from 1 day to 60 months
• Pay no early repayment fees

Start funding your business with iwoca

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