Business Owners and entrepreneurs alike must understand the importance of business financing to grow their company, sustain operations, or engage in capital intensive projects. With the rise of alternative lending platforms such as online based credit funds or business banking arms expanding their presence, financing is an eventual method for growth. Of course, financing won’t need to be an option if your company boasts the balance sheet of firms such as Samsung or BMW. If your business is looking to expand, but cash flow is tight, debt financing in the forms of small business loans or bridge financing are options to facilitate expansions and business acquisitions.
A simple introduction: What is debt finance?
Debt is a common form of financing, and is not only existent in the realm of businesses and firms, but also at the micro and personal level of an individual. Think of loans pertaining to automobiles, or more prominently a mortgage on a home. These are very simple forms of debt financing which assist an individual in the acquisition of an asset, may that be a home or other personal assets. In the business world, the concepts of principal and interest payments apply, but for your business. This debt is provided by banks or alternative lending institutions, or even private investors who look to be paid back with interest.
The General Process:
Generally, when a small business owner heads to a bank for financing, they fill out a form, and are asked to provide financials. Banks are known for utilizing cash flow based analysis to determine debt serviceability and assess the creditworthiness of a client. A similar process occurs at other financial lending institutions who provide business loans. If your business is in the early stages of its operations it is likely that personal credit will be assessed to come to a lending decision.
Businesses operating via a more complex corporate structure will have a longer due diligence process, with careful cash flow analysis, credit analysis and deep dinging into the books to assess profitability and debt serviceability.
It is essential, regardless of the magnitude of business operations, you the business owner provide complete and accurate information when preparing for a loan. Doing so in a timely manner will assist you in making a decision quicker, economizing the process of long term business planning. If approved by either a bank or alternative lender, you will be set up with a term, interest rate, and payment structure.
Let’s explore some Advantages of Debt financing:
There are some particular advantages when a business obtains debt financing. When provided with financing, the lending institution holds no say in how you run your operations. In essence your autonomy of operations and how you chose to run operations is not hindered whatsoever. Whilst other types of financing, such as equity, may result in shareholders dictating some terms such as influencing management or adopting certain business policies via voting rights. With debt financing, once the debt has been paid back, the business loan relationship with the lender is over, thus allowing you to attain lending or investment relationships with other lending institutions. Whilst with equity financing for an example, a shareholder generally remains a part of the company, even when all funds provided are fully utilized. In terms of business planning and budgeting the fixed structure of debt payments can easily allow you to conduct financial and business related forecasts. This is essential when aiming to project cash flows and make major business decisions in the long term. Incorporating the debt financing expense in your projections is done so in a fixed cost method, reducing the headache of any variability, which affects long term business planning and budgeting. Due to the static nature of the financing structure, business owners are able to devise plans for operational expansion with ease. Such projections play a major role in attaining long term assets and investments. There happen to be some tax incentives associated with business loans in particular as well. All interest payments are tax deductible and can be paid off as a business related expense.This proves advantageous for business owners.Certain loans in Canada such as mortgages do not have this aspect of tax deductibility. Lowering your tax liability can prove favourable for business owners as this can aid in earning more business income. Increased business income can result in driving more investment or acquisitions of additional productive units which then garner further profitability. Finally debt financing can be offered to businesses absent of collateral,this may be very attractive to business owners who are not comfortable putting their assets up as collateral. Though a higher rate may apply, it is usually accompanied with some form of early payout incentive. Commonly known as unsecured or cash flow based financing. These types of loans are provided purely on the cash flow performance of a business, omitting the analysis of assets, thus excluding them from the financing structure, essentially quickening the process. In recent years, young businesses, or businesses that are not asset rich, turn to such financing, and attain funds in a timely manner.
There are however some disadvantages to attaining debt financing.
Adding debt to your expenses may increase your expense burden. As a result this may hinder operations and may affect salaries and business income. Paying back a loan can prove to be an extraneous experience if the decision to attain financing happens to be taken in a rushed manner. Hence why it is always important to assess internal profitability, liquidity and cash flows to assess if attaining a debt burden will prove profitable and not costly. There is also a macro based disadvantage to debt financing. Economic recessions and downturns in national economic performance produce crunching effects on available credit and available financing. During this period of time it may be difficult to attain financing, unless you are overwhelmingly profitable and efficient as a business. Hence why business owners should be aware of macroeconomic trends such as interest rate movement, and pounce on the right time to attain financing. Secured financing is a form of debt financing including the presence of collateral in the financing structure. If failures in payments occur, this may lead to a seizure of that particular asset. This is not a favourable occurence for any business owner, hence why careful projections and cash flow analysis should be used to make such decisions if looking for secured forms of financing. It is essential to display good financial discipline when utilizing and attaining debt financing. Poor management of the debt acquired can lead to long term business repercussions, such as the damaging of one’s business credit score. Essentially increasing the risk profile of your business, which can deter investment and other forms of financing (especially debt financing and equity financing).
However if procurement debt financing is thoroughly planned via careful internal analysis and sound financial judgment, debt financing can be a very attractive option to business owners.
Hence, debt financing can be a very productive and a powerful tool to grow your business. The fixed structure and development of a relationship with a financial institution can be quite fruitful and advantageous in the long run.Relationships with bankers and financial advisors can lead to many opportunities to expand and grow operations. The ability to easily model in expenses for projections to aid proper business planning and decision making is a bonus as well. These are a few yet important elements that provide business owners a lot of benefit when obtaining debt financing. However, the decision to attain such financing should not be taken lightly, and careful planning should be an important aspect of the loan attainment process.
If you are a business owner who is curious about debt financing structures and how you can have them tailored to meet your needs, please connect one of our account managers. We at kingsmen strive to provide quality advice and service to assist our clients in transforming their business to a profitable entity.