Business Funding – Debt financing explained
Debt Financing
“Money is always there, but the pockets change.” Gertrude Stein
Debt financing refers to what we normally think of as a loan. A creditor agrees to lend money to a debtor in exchange for repayment, with accumulated interest, at some future date. The creditor does not obtain any ownership claim in the debtor’s business. Debt financing is attractive because you do not have to sacrifice any ownership interests in your business, interest on the loan is deductible, and the financing cost is a relatively fixed expense.
Selecting a Bank or Other Lender
- Banks include traditional savings banks, savings and personal loans, and commercial banks, and are generally the first place small business owners think of when looking for institutional financing.
- Credit unions can offer generous terms to their members, but make mostly consumer loans.
- Consumer finance companies may be willing to make higher-interest loans to higher-risk borrowers.
- Commercial finance companies may be worth considering if you need a loan for inventory or equipment purchases.
Specific types of bank loans: In addition to consumer loans and mortgages, the most common types of loans given by banks to startup and emerging small businesses are:
- working capital lines of credit for the ongoing cash needs of the business
- credit cards: higher-interest, unsecured revolving credit short-term commercial loans for one to three years
- longer-term commercial loans: generally secured by real estate or other major assets
- equipment leasing for assets you don’t want to buy outright letters of credit for businesses engaged in international trade
The Real Cost of Borrowing Money: The final cost of borrowing money often involves much more than just the interest rate. A variety of other monetary and non-monetary costs should be considered in determining the real cost of borrowing. For example, a loan that requires you to maintain certain financial ratios may be unrealistic for your particular business. Your checklist for reviewing the costs of a bank loan should include:
- Direct financial costs, such as interest rates, points, penalties, and required account balances
- Indirect costs and loan conditions, such as periodic financial reporting, maintenance of certain financial covenants, and subordination agreements
- Personal guarantees needed to obtain the loan
What Banks Look For
“Remember, the guy who writes the bank’s advertisements is not the same guy who approves your loan.” - Anonymous
Whether you are applying to a bank for a line of home equity credit, a line of credit for business working capital, a commercial short-term loan, an equipment loan, real estate financing, or some other type of commercial or consumer loan like HomeXpress bank statement loans, many of the same basic lending principles apply. The most fundamental characteristics a prospective lender will want to examine are:
- credit history of the borrower
- cash flow history and projections for the business
- collateral that is available to secure the loan
- character of the borrower
- loan documentation that includes business and personal financial statements, income tax returns, and frequently a business plan, and that essentially sums up and provides evidence for the first four items listed .
Asset-Based Financing: To generate working capital or to meet specific short-term cash needs, small businesses may use certain short-term assets as collateral for commercial loans. The most common types of asset-based financing are the following:
- Accounts receivable financing uses the receivables as collateral. As the business collects the receivables, the proceeds are used to repay the loan or line of credit.
- Inventory financing is a similar type of loan, using inventory as collateral.
- Factoring is a process whereby accounts receivable are actually sold to a third party (the factor) for a discount price, after which the factor takes on the job of collections.
Leasing: Leasing companies, as well as banks and some suppliers and vendors, will rent equipment and other business assets to small businesses. Some manufacturers have leasing agents who may be able to arrange lease terms or a credit arrangement with the manufacturer, a subsidiary company, or a specific lessor. Leasing assets, rather than purchasing them, is a form of financing because it avoids the large down payment frequently required for asset purchases and it frees up funds for other business expenditures. However, you should be aware that leasing from conventional lenders may be difficult for startup businesses because traditional lenders require an operating history from prospective lessees.
Trade Credit: Your suppliers and your customers represent possible sources of financing through a variety of credit and pricing options.
“Trade credit” is the generic term for a buyer’s purchase of supplies or goods from a seller (supplier) who finances the purchase by delaying the date at which the price is due, or allowing installment payments. Vendors and suppliers are often willing to sell on credit and this source of working capital financing is very common for both startup and growing businesses. Suppliers know that most small business rely primarily upon a limited number of suppliers and that small businesses typically represent relatively small order risks; as long as the supplier keeps a tight rein on credit terms and receivables, most small businesses are a worthwhile gamble for future business.
Insurance Companies: If you have substantial cash surrender value in a life insurance policy you can usually borrow up to that amount from your insurer. Ordinarily, you would borrow against the policy and then re-lend the money to your business at the same interest rate. The business can then take an interest deduction on the loan and you do not earn taxable interest income on the transaction.
When you borrow against your own policy, you are not obligated to repay the loan principal, only to pay interest on the loan. Interest is typically due on an annual anniversary date. Most policies will allow you to simply add the accumulated interest to the principal, as long as you have not already borrowed up the cash surrender value of the policy. The rate of interest charged depends upon when the policy was purchased; rates on older policies might be very favorable. Of course, borrowing against your own policy means the eventual death benefit of the policy will be diminished by the amount of the loan, plus the loss of interest.
