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Debt Financing Explained for SME Owners

If you’re a small to medium enterprise (SME) owner here in the UK, no doubt you’ve been feeling the pinch in recent years.  Raising money to grow your business can be a scary prospect – you want to increase your business, but worry that you’ll find it difficult to pay back any loans you take out in order to do so.  When it comes to raising business finance, there are several options open to you, including:

·Applying for government grants and regional funding

·Equity – giving away shares in your business in order to secure the necessary funding

·Crowdfunding – using platforms to market your products or equity in return for funding

·Debt funding

 

Today we’re going to take a look at debt funding (also known as debt financing) to ascertain what it is and what are the pros and cons. Firstly, let’s explain that debt financing is basically money that you borrow to run (or grow) your business, as opposed to equity financing, where you raise money from investors in return for a share of the profits from your business.  Debt financing can be divided into two categories:

Long Term Debt Financing – usually used to purchase assets such as equipment, buildings, land or machinery.  In long term debt financing, the scheduled loan repayments and the estimated useful life of the assets you purchase will extend over more than a year and the lender will normally require that the loans are secured by the assets you purchase with them.

Short Term Debt Financing – this is usually money that’s needed for the day to day operations of your business, such as buying inventory, supplies, etc. or paying the wages of any employees.  Short term financing is often referred to as an operating loan and the scheduled repayments last less than a year.

 

The advantages of short term debt financing include:

·You maintain ownership of your business and retain the right to run the business how you want to.

·In most cases, the principal and interest payments on your loan are classified as business expenses and can be deducted from your business income at tax time.

·Check out the impact of tax deductions on the bank interest rate – if the bank is charging you 10% for your loan and the government taxes you at 30%, there’s an advantage in taking a loan you can deduct in this way.

 

However, it’s not always a bed of roses and there are drawbacks to debt financing, including:

·Repayments – your sole obligation to the lender is to make the payments, even if your business is in trouble or fails completely.  Should you be forced into bankruptcy, your lenders will have a claim to repayment before any equity investors.

·Even after taking into account the discounted interest rate from your tax deductions, you may still face a high interest rate because these vary with macroeconomic conditions, your history with the banks, your business credit rating and your personal credit rating.

·If you’re tempted to “lever up” and keep borrowing to keep your business afloat, each loan with be noted on your credit report and affect your credit rating.

·If you plan on using the loan to invest in a vital asset, you need to make sure the business will generate sufficient cash flow by the time repayments are due to begin.

 

Next week, we’ll take a look at some of the alternatives to debt financing.