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The Advantages and Disadvantages of Debt Financing

Whilst most small to medium business owners will try to avoid falling into debt, with many finance experts considering debt to be avoided at all costs, this really is an over-simplification.  Not all debt is bad and taking on a debt can be beneficial to your business in the long term, depending on how you plan to use the borrowed money and the cost of borrowing it.  Under the right circumstances, this is a leverage that can help you to preserve cash and put an otherwise illiquid asset to work on building your net worth.

When you need to raise money in order to start a new business or expand an existing business, you may be wondering whether to secure the finance using equity funding or applying for a loan.  Today we’re taking a look at the advantages and disadvantages of deb financing.  Debt finance is borrowed money that you must pay back (with interest) within an agreed timeframe.  The most common methods of debt finance include overdrafts, bank loans, mortgages, credit cards and leasing/hiring equipment.

Large corporations often use debt to optimise their capital structure.  For instance, rather than using cash to buy a new car, taking out a low interest, 72-month loan means that you can invest your cash in a fund that offers a greater return than the low interest you’re paying on the car loan.  Not only will you be “quids in”, you’ll have improved your credit score too (as long as you’ve kept up with the monthly payments).

However, before rushing to take advantage of cheap debt, you should fully consider the risks involved.  Rising interest rates may affect both your income and the value of the assets being used as collateral, especially if the rising interest rates set off an economic downturn.   This means that accruing low-cost levels of debt right now may result in you being forced to refinance the debt at higher rates of interest in the future. 

Take a look at the advantages and disadvantages of debt financing:

ADVANTAGES OF DEBT FINANCING

DISADVANTAGES OF DEBT FINANCING

Maintaining Ownership – unlike equity financing, debt financing allows you complete control over your business.  As the business owner, you do not have to answer to any investors and can run your business how you choose.

Accessibility – banks can be conservative about lending money and a new business owner may find it difficult to secure debt finance.

Retaining Profits – the only obligation you have is to make the regular repayments on the loan and pay it off within the agreed timeframe.  You will not have to share your business profits with investors.

Repayment – you need to ensure that your business generates enough income to service the debt (repayments + interest) and if your business should fail, you are still obliged to repay the debt.

Tax Deductions – interest fees and charges on a business loan are tax-deductible.

Cash Flow – committing your business to making regular repayments may have a negative effect on your cash flow which could make regular repayments a challenge.

Credit Rating – keeping up with regular payments and repaying the money borrowed within the timeframe allowed will have a positive impact on your credit rating.

Credit Rating – late or skipped payments will have a negative effect on your credit rating, making it more difficult to borrow money in future.

 

Bankruptcy – unless you have a guaranteed way of paying back the loan, you risk potential bankruptcy.  This would be even more serious if you’ve pledged personal assets to secure the loan.