Debt financing guide for small businesses

Debt financing

Debt financing is the process of raising capital by the way of instruments like bonds, shares, mortgage etc. to investors or financial institutions for starting and operating the business. The businesses of all sizes need to raise capital at initial as well as progressive stage. While choosing the debt financing option and size, one must be sure of the repayment plan. Defaulting on repayment can lead to loss of asset or whole of the business in the worst case scenario.

Here is a quick guide for the small business owners who decide to go debt financing way to bring their vision into form.

Types of debt financing

Depending upon the kind of asset put as collateral to raise money, there are following types of debt financing options available for small businesses:

a. Short-term loan: As an aspirant of starting small business, the entrepreneur needs testing waters. Thus, the short-term loan proves to be feasible option. The amount raised is small, too, in order to avoid big risk. Interest rate can be a bit high for short term loan. However, if you compare the total interest that goes into long term loan, this loan turn out to be cheaper. Normally, financial institutions deal in this type of loan and not banks.

b. Bank loan: Small businesses who are confident of turning into big entity in a definite period of time can turn to banks to avail credit facility. The bank loan is available in the form of overdraft facility, mortgage loan, and loan against property or shares and so on. Some banks offer gold loan where the borrower keeps the gold jewellery as collateral for raising money.

c. Trade credit: It is a kind of understanding more than loan. The vendors and suppliers in order to gain more customers offer the trade credit option. They keep selling essential supplies to the small business and maintain paper of credit. The business owner, according to the terms of understanding, clears the bills of vendor at dates chosen. In this arrangement, there is no actual money given to the borrower but materials are provided on credit.

d. Asset-based financing: Small businesses can use the receivables and inventory value to show their capability to repay loan. They can also pledge the receivables or inventory to the lender in order to get required money and raise capital for business

e. Policy loans: Those people who have got high ticket insurance policies can use this avenue for raising money for business at small scale. The lender gets assurance of repayment in the form of policy maturity value. The business owner can get the ownership of policy back by repaying the loan within stipulated period.

f. Credit cards: Banks issue credit cards to the select customers who maintain good standard of living or high account balance. A small business owner can take the money from credit card and raise capital needed for stating the venture. Ease of repaying small amounts may take away financial woes. However, be ready to face high interest rate!

Which entities to consider for debt financing for small business

Debt financing for small businesses facility is available with various types of lenders. Some of the important ones are:

a. Banks: Banks are the primary borrowing points for small entrepreneurs. They prefer going to these because of structured repayment procedure and professional set-up of services. By approaching banks, the borrowers enjoy secrecy of the business idea too.

b. Consumer finance companies: These companies are approached by those entrepreneurs whose ventures fall in high risk category. These lenders grant loans but at very high interest rate owing to the risk involved. They involve minimum paper-work. The borrowers who need to finance inventory or equipment purchases approach these companies normally.

c. Credit unions: One can also choose to avail membership of credit unions. The members get to enjoy loans for small businesses on easy terms from the credit unions.

Things to be aware of while choosing debt financing

Debt financing is not something any person gets into every day. For the first timers, it is as mysterious as venturing into an unknown forest. So, to be successful in your attempt of raising capital by debt financing, you must take care of following points:

a. Be aware of the terms used for loan purposes: Raising capital by the way of financing requires dealing with certain terms which are peculiar of loan world. Thus, you must pick the lingo first so that you know what is being discussed.

b. Hire a legal expert: This is required when you want to take loan which involves contracts and other related documentation. Legal expert can help you find any loopholes or enable including favorable propositions. 

c. Go for low interest options: Loan for raising capital, if available at low cost, can help earn bigger margins. It also helps keeping expenditure within reasonable realms.

d. Pick time frame for repayment wisely: In an attempt to raise quick money, newbies may give into the temptation of accepting to smaller time window for starting repayment. It also happens out of over confidence and incorrect reading of prospective consumers’ sentiment. Whatever is the reason, the strategy of picking repayment within short period can backfire.

e. Take loan from professional lenders: Though friends are support system, this pool should be tapped only when you do not have any resource left to explore. Relationships based on money can get spoilt if the terms of repayment are not met.

Is debt financing a safe bet?

Loans do involve an element of risk. Debt finance is no exception. The businesses that are confident and has done their SWOT correctly may find debt financing a help rather than threat. HoweverDebt financing, it is always advisable to pose borrowing restriction in terms of amount to be able to tackle contingencies. 

To conclude

Debt financing is not something new. It has been around since the concept of business was introduced. People require knowing about it only because they never came across this requirement before the idea of starting business. 

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Jul 29, 2020

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