Debt Financing: Good or Bad for Business?
Debt financing for businesses is basically a simple loan from a source outside the business. The business makes an agreement and promises to return the principal along with any interest accrued. If debt financing is managed properly, it can be a great way to help any business grow to the next level. Managed poorly, and the business could face financial ruin or bankruptcy.
As a term, debt financing doesn't really have a positive reputation among most business owners. However, many companies, especially start ups use debt to finance their day-to-day operations. Big corporations will often carry some level of debt on their corporate balance sheets. Among corporations, leverage is the term frequently used to refer to debt financing. The typical sources of debt financing are banks or financial institutions. However, debt financing can come from just about any source like another privately held company, friends, or even family.
Debt Financing Has it's Advantages
The biggest advantage to debt financing, or leveraging a company is the tax deductions. The principal amount of the business loan along with the interest payments are considered as business expenses by the IRS. This handy fact allows business to dedcut the entire amount of principal and interest from their business taxes. Think of it this way: if the corporate tax rate is 30-percent, then essentially, the government owns 30-percent of your business. Anything that reduces that control, like getting a juicy tax deduction, is going to be a plus for business.
Keeping a controlling interest in your business is important. After all, it's your business and you want to run it your way. In most cases of debt financing, the person, company, or institution providing the loan has no control. Typically, the only obligation that your business has is to pay back the loan according to the terms of the note. If you have any concerns about this matter with e lender, be sure to make it part of the agreement that you will maintain control.
Debt financing may lower the interest rate on your loan. The amount of your tax deductions will lower the total amount of interest you pay on the loan. As an example, let's say Uncle Sam taxes you at 33-percent and your lender is charging you 12-percent on the loan. Take that 12-percent and multiply it by 1 minus your federal tax rate, in this case 33-percent. The equation would look like this: 12% x (1 - .33) = 8.04%. In this case, your after tax interest rate would essentially be 8.04-percent. Now that's good business.
Potential Problems With Debt Financing
Even though leveraging debt by borrowing more seems a good thing to do for a business that needs cash, it may not be the best thing to do. Every additional loan that you take out is going to be recorded on your credit rating. As your business borrows more and more, interest rates could become higher and higher. The lender's risk increases each time you borrow more money.
A loan is a loan and you will have to make those payments on time or face possible default. If you take the loan and your business still does not make it, then you will still have to repay the loan. If you go bankrupt, these lenders will have first claim to any money that is left.
Sometimes it's just impossible to get a decent interest rate, even if you have good credit. A high interest may be a deal-breaker in some circumstances, even when figuring a discounted rate after tax deductions. Be certain you can repay the loan before signing anything. There may be other alternatives. You do not want to adversely affect your borrowing history with the bank, your business or your personal credit rating.
Methods Other than Debt Financing
There are other ways to get financing for your business. Equity financing sells shares of the company to those interested in investing. You may even choose to finance your business with your own money. Some lenders will offer a type of unsecured loan with a very high interest rate. These type of loans have an option which may allow the lender to convert any debt into equity if you default. Banks typically do not want control of a business and may work with you to work out an alternative solution.
Most companies will use a combination of several methods to finance a company and bring needed cash into a business. This "hybrid" financing is usually a combination of debt and equity financing combined together. The problem with hybrid financing is finding the right balance between debt financing and equity financing. Consult your trusted financial adviser or CPA for more specific details that pertain to your particular situation.
