Unless your business is operating on a balance sheet that is similar to that of Amazon, one eventually needs to attain capital through financing. Even with ample cash flow still issues debts. As a matter of fact, there are many large-scale companies that often seek capital infusions to achieve short-term, long-term objectives.
As a small business owner, you do understand that there are times when you can be short of cash flow. Even with the availability of loans, there are business owners who don’t know when the appropriate time to apply for one is. Some businesses even shy away from taking advantage of borrowing opportunities due to a lack of knowledge. Wait ‘til I need mentality.
On the other hand, other businesses rush to borrow money for the wrong purposes or at the wrong time. In any circumstance, it’s critical to recognize that there are excellent reasons to borrow money, as well as terrible — and even worse — reasons.
When business owners – small or large – need money to operate their day-to-day business, they have to access financing outside of their business. In most instances, debt financing is usually the best option. Other may be available but for most small business debt through unsecured and secured business loans, terms loans and even merchant cash advance are the only options.
What is Debt Financing?
Debt financing for small businesses is basically the practice of borrowing money from a third party in order to keep the business running. According to the conditions of the loan, the business owner is liable for repaying the principal amount plus a percentage fee of interest.
When you think about debt financing, you would visualize borrowing money from a bank in order to receive a bank loan. However, depending on the complexity of the business and its capacity to repay the loan, there are a variety of different debt financing options. It all comes down to the riskiness of the business and its stage in the life cycle process. Each offers its own advantages and disadvantages.
Advantages and Disadvantages of Borrowing Money
There are several businesses debt financing advantages and disadvantages to consider before borrowing money from a third party. These must be carefully taken into consideration. It’s very important to keep in mind that what works for one business may not necessarily work for another.
- Stay one step ahead of the competition
Despite present economic instability, the number of small and medium-sized businesses (SMEs) continues to rise. With so much competition in the market, it’s even more important that one keeps investing in development and growth. If one doesn’t have the means to keep up, borrowing money might give one the push they need to stay ahead of the pack.
- Adapt to the times
Having the most up-to-date technology, plant or gear may aid in improving operations, therefore, increasing efficiency, and taking on larger orders. However, obtaining the required operating capital to complete these acquisitions might be difficult. By borrowing money, the business is able to obtain the capital it needs and make significant acquisitions that it otherwise would not be able to do.
- Reinvesting to bring in more money
While borrowing adds to a company’s expenses, it’s often possible to make more money by investing than it costs to borrow. Businesses can benefit from new possibilities as they occur with better access to operating cash. This might result in a rise in revenue and profit.
- Boost your credit score
You may dramatically improve your company’s credit score by borrowing money and making timely credit payments. This makes it far easier to obtain larger credit in the future, allowing one to continue to thrive.
- Increase your working capital
When a company operates on credit terms, working capital might be strained because suppliers must be paid before consumers pay up. When a business is growing quickly, this may become much more of an issue, necessitating continuous borrowing to ensure that enough money is accessible at all times to satisfy day-to-day obligations.
- Enjoy the benefits of discounts
Accessibility to cash flow might help your business take advantage of early settlement discounts and other supplier benefits. This can help your business save money that could be put to greater use elsewhere.
- Increase your flexibility
The amount of capital one can access via invoice finance rises in step with the sales ledger, providing one additional flexibility even if they’re utilizing the money to meet day-to-day objectives or to support expansion. This is especially beneficial for temporary or expanding businesses that might have to modify funding to match their demands.
- Repayment is mandatory
If a company utilizes debt financing is borrowing money, it must pay it back. Irrespective of their working capital position, they must repay principal and also include interest. Even if the company goes out of business, the obligation must be paid. If the business is pushed into bankruptcy, the lenders are entitled to claim for repayment even before the equity investors.
- Negative cash flow
Because principal and interest payments must be made on the loan, a business that relies so much on debt financing will have reduced working capital. A company’s debt-to-equity ratio can be used to assess its dependence on debt funding vs equity financing. It’s preferable if the ratio is as low as possible. One of the most common issues that small businesses confront is a lack of or negative cash flow.
- Risky collateral
To acquire debt financing, several small businesses may be forced to present collateral. Many company owners are wary of collateral since it sometimes requires them to utilize assets that they own privately, such as their houses.
- Credit rating
When the business needs money, it may seem appealing to keep taking on debt. This strategy is known as “leveraging up”. However, each borrowed loan is usually reported on one’s credit report and has an impact on credit rating. Because the lender’s risk increases when one borrows more, they have to pay a greater rate of interest on each succeeding loan.
Advantages and disadvantages of not borrowing money
- Focus on growth
A business with tiny margins doesn’t have to bear the burden of paying up loans. They might seem like an alluring prospect but all they do is bring additional mandatory costs that are time-sensitive.
- Solid organizational structure
The organizational structure of a small business should grow organically with time. When it grows, the business plan also evolves. If it doesn’t change correctly, there will be mistakes that will result in losses. Businesses take huge losses especially when they decide to take a loan during such rocky periods.
- Not running into more debt
It can sometimes seem enticing to take a small business loan to pay off other debts. It could be because working capital has depleted or there are high-risk assets involved. Whatever the case, it rarely works in one’s favor. New loans only add more and more expenses without fixing the initial problem.
Alternatives to Debt Financing
- Crowdfunding – Small businesses can occasionally use one of the many net’s crowdfunding sites to raise funds.
- Savings – Internal equity financing is money borrowed from savings and contributions from family and friends.
- Mezzanine financing – this is a combination of debt and equity financing that allows the lender to convert to an equity stake in the business in case there is a default, usually after venture capitalists and other senior leaders have been paid.
- Credit card financing – One may use credit cards to fund the business, but they will have to pay a high-interest rate and adhere to stringent payback conditions. The feasibility of utilizing credit cards depends on the credit history as well as the quantity of money the business requires.
While there are reasons why a business should not take out loans, there are other reasons why a small business must. If you don’t have you calculated the opportunity lost for not borrowing and have you as well provided enough attention to the cost and benefit analysis to make the right business decision not just for the short-term aspect of your decision making, but for the long-term. If cost applied heavily once however high as long as your revenue would amount to a perpetual cash-cow business, should you give up borrowing? Small business loans are great for expanding your business or covering particular expenses like inventory just before the busy season starts.
If a business has the ability to grow with access to capital, the wise approach from leveraging future revenue should be considered in business decisions.
It is typically better for one’s business if one can avoid borrowing money from an official source. Debt financing is likely the simplest source of cash flow for small enterprises if one doesn’t have relatives or friends that can help.
As the company grows and evolves through various stages of product development, it is advisable to seek other better options such as mezzanine funding or equity financing. Less is more when it comes to finance and how it will affect your business. Those who avoid borrowing don’t know what big opportunities they are missing.