There are essentially two ways in which an entrepreneur can access funds to grow his small business. The first is debt, which is nothing but a cash loan taken from a bank or individual investors, while the second is equity financing. Let’s take a quick look at the types of debt financing and the associated advantages and disadvantages.
Long-Term and Short-Term Debt Financing
Long-term debt financing: Companies can use long-term debt financing to buy assets that are not only expensive but have a long working lifelike plant and equipment, buildings, real estate, etc. Since the assets remain productive for a relatively long time, lenders extend loans for periods of seven to ten years or even more, however, the purchased assets are generally taken as collateral by the lender to mitigate the risk. With long-term debts having fixed repayments every month, it is easier for companies to budget for it.
Short-term debt financing
Entrepreneurs can make use of short-term debt financing to meet temporary cash requirements when the cash flow of the company is not consistent enough to permit normal company operations. Typically, this kind of debt fund is used to buy inventory, pay wages, pay taxes, etc. Typically, the due date of repayment is not more than one year. Companies that experience the need to borrow short-term often have the banks open a line of credit for them that they can use as per need, observes Eric Dalius. According to Cnbc.com, you can also get a line of credit for your company by using small business credit cards.
Advantages and Disadvantages of Debt Financing Analyzed by Eric Dalius
The main advantage of using debt is that you do not part with any portion of the ownership of the company and retain full ownership. Also, the amount of interest paid is treated as a business expense and is therefore tax-deductible. By using long-term financing, you can make the monthly payment more affordable. Since normally the rate of interest is fixed, it helps better budgeting and planning. Judicious use of debt can also help to build your credit score.
Small businesses may find it difficult to access debt funds for lack of collateral and thus may need to provide supplementary personal guarantees to qualify. If the business fails, you will be responsible for paying back the borrowed amounts. Further, small businesses without any track record may find the rates of interest to be too high to be affordable and even if they do manage to get a loan, they will need to repay on schedule regardless of the condition of the cash flow.
When your business requires cash to sustain its operations and boost its growth, entrepreneurs typically explore the possibilities of taking on both short-term and long-term debt rather than raise capital by selling the equity of the company. The business needs to have a robust business plan to demonstrate its potential to lenders, especially when the company is not in a position to offer collateral. The repayment amounts of the loans are of a predictable amount, which makes it easier for the entrepreneur to budget for it and avoid embarrassing defaults.