Debt financing for businesses: Advantages and disadvantages

When running and growing a business, a cash boost can be a game changer—especially one that doesn’t require you to give up ownership of your company. That’s why a lot of businesses use debt financing to borrow money—typically in the form of bank loans or bonds—with the agreement to pay it back with interest over time. This financial strategy can open the door to new business opportunities, but it also comes with its own set of risks.

Keep reading to learn more about the advantages and disadvantages of debt financing to determine if this type of financing is right for your business.

What you’ll learn:

• Debt financing is a business funding strategy that enables businesses to borrow capital from individuals or investors through bank loans or bonds. This means the individual or investor becomes a creditor and the funds must be paid back with interest.

• Some advantages of debt financing include maintaining company ownership, gaining access to cash to help fuel business growth, and the ability to deduct interest paid from your taxes.

• Debt financing might not be ideal for all businesses because of the potential for higher interest rates, the need for steady business income and the possibility that collateral might be required.

While you might think of debt as a bad thing when it comes to personal finances, having some form of debt can actually be a good thing if it fuels business growth. Debt financing can take the form of a few different funding options:

• Bank loans

• A loan from family or friends 

• A business credit card

• Bond issues 

Here are some of the advantages of debt financing.

There are two types of debt financing methods you can use to expand your business—short term and long term. Short-term debt financing is when you borrow funds for a short window of time to cover your day-to-day business expenses. It often takes the form of a line of credit that you pay off in less than a year and can be instrumental in improving cash flow. Short-term debt financing can fund operational expenses such as:

• Wages

• Inventory

• Supplies or maintenance

• Unexpected costs      

Long-term debt financing is paid over an extended period of time—typically up to 10 years—and can have a fixed interest rate and equal monthly payments. You can use long-term debt financing to purchase larger assets, such as:

• Equipment

• Real estate

• Machinery 

Because debt financing is considered a business expense, interest paid is tax deductible in most cases. This means you can deduct payments made toward interest from your business’s income at tax time.

If you want to retain control of your business, you might choose debt financing over other types of financing strategies. Rather than partner with investors who would get a stake in your company, you would borrow the funds from a lender and repay them over time with interest. This allows you to keep all your profits and remain the primary decision-maker in your company.

On the other hand, equity financing—another popular financing strategy—enables you to gain access to capital by selling shares of your company. While equity financing dilutes ownership of your company, it could be ideal if you’re not looking for a financing option that has a repayment obligation. Keep in mind that many business owners choose to finance their company through a mix of debt financing and equity financing as part of their business plan.

When you use debt financing to stimulate growth, you might take out a bank loan or use a business credit card. If these creditors report to business credit bureaus, you could build business credit with responsible payment habits. Building business credit can have a host of benefits, such as better interest rates and repayment terms on future loans or lines of credit—which can promote further growth in the future.

And if you’re a new business owner or sole proprietor and used your Social Security number (SSN) to secure a business credit card for debt financing purposes, responsible use could positively affect your personal credit.

Certain types of debt financing can have lower interest rates—but the options available to your business can vary. For example, SBA loans are government-backed and typically let you pay down the loan over a longer period of time—and at a lower interest rate—than conventional loans. But keep in mind that the SBA loan application and approval process may take longer than other types of debt financing options, which can be challenging if you need funds more quickly.

While debt financing can be a strategy to help your business grow, there are some considerations to keep in mind before you leverage debt for your company.

Depending on the type of debt financing you’re trying to secure, you may need to meet certain criteria—which can vary, depending on the creditor. For example, certain guidelines could be:

• Having a set amount of business revenue

• Meeting a certain credit score threshold

• Being in business for a minimum number of years

Understanding the eligibility requirements before applying for credit can help you get a better idea of what you may qualify for and which options to pursue. For example, if you’re interested in a business credit card, you can get pre-approved first to understand the different types of credit card offerings available to your company.

Because debt financing typically requires regular payments on the principal and interest, lenders often require a consistent source of income. This may be difficult if you own a seasonal business or a startup with fluctuating income, for example.

Before you’re able to take out a business loan or line of credit, you may need to pledge an item of value to lenders—also known as collateral. This protects the lender if you were to default on payments because the item you use as collateral could be seized and sold to recover any losses. 

For example, equipment financing—one type of debt financing—lets business owners borrow funds to purchase business equipment, such as machinery or vehicles. Typically, the equipment itself becomes the guaranteed collateral if you were to default.

While debt financing can help build business or personal credit with a positive repayment history, it can negatively impact your credit score if you don’t make your payments on time. And this could have larger implications for your ability to borrow funds in the future and the loan terms you may receive. This is why it’s important to establish a plan for how you can pay off your business debts promptly while still keeping your cash flow running smoothly.

Certain types of debt financing can come with lower interest rates, which can help keep more funds in your business’s wallet. But there are other types of debt financing options that could come with higher interest rates. Before you secure any type of financing, be sure to understand the total cost of borrowing by reviewing the interest rate, APR and loan payments.

There are a few questions to ask yourself before determining whether debt financing is the right move for your business.

There are various types of debt financing, and each has its own requirements and benefits. For example, in addition to bond issues, lines of credit and loans, other options could include:

• Merchant cash advances: This refers to a lump-sum payment made to your business in exchange for your projected future credit or debit card sales.

• Convertible debt: This type of financing—sometimes referred to as a convertible bond—is considered both debt financing and equity financing because it involves changing a loan into fixed equity shares in your company.

• Trade credit: This is a type of short-term debt financing offered by suppliers that allows businesses to make a purchase at the moment but pay later—typically 30 or 60 days after the transaction. This can be helpful for businesses that need time to manufacture products and generate revenue before paying the invoice.

• Equipment financing: Equipment financing extends funds to businesses that need to purchase items like vehicles, machinery or technology, using the equipment as collateral.

You might consider other funding options outside of debt financing, such as:

• Equity financing: Equity financing involves selling ownership shares of your business to investors in exchange for an ownership stake in the company. But the investors can play a larger role in the decision-making process, as they’re typically tied to both profits and losses. This option may be ideal for your business if you’re looking to raise capital without taking on debt, though it does involve giving up some level of ownership.

• Government grants: Another option to help fund your business is a government business grant. These grants can come from either federal or state governments and are often provided by donors. With a government business grant, funds are typically intended to be used for specific purposes and can be difficult to qualify for because they don’t require repayment. 

If you plan on using debt financing, it’s important to keep in mind that most options require regular monthly payments toward the principal and interest. If your business’s income is unpredictable, it might be difficult to secure certain types of debt financing based on lender-specific requirements. And you could risk missing a payment, which could hurt your credit.

While many businesses use a mix of debt financing and equity financing, there may be situations where you need to maintain full ownership of your company. In many cases, it can be difficult for smaller companies, especially in the early stages, to secure equity financing. In these cases, it might make sense to maintain full company ownership and rely solely on debt financing.

Debt financing is one way to help expand your business—but the way you leverage debt can depend on your company’s specific needs and goals. One popular debt financing option is using a business credit card to gain access to funds that you can use to stimulate growth. Capital One offers a variety of business credit card options, and you can get pre-approved to see which cards you may be eligible for—without impacting your credit.