If you are a small business owner, or you are a burgeoning entrepreneur who is about to enter the world of company ownership, operating with debt is likely to become a way of life.
That’s not necessarily a negative prospect, depending on how you go about managing that debt.
But, unless you are flush with so much cash that you can operate a new company without financing any of your expenses, the only other way that you’d be able to launch and run a small business without the specter of debt is if you are a recipient of equity financing.
Equity financing is when the proprietor of a business sells a stake in the company to investors in exchange for capital.
Any small business owner, though, who is not employing equity financing and who does not have scads of cash on hand to run a company without any financing, is going to face the reality that debt financing is the most common avenue to funding a new — or ongoing — operation.
For those wondering what a good debt ratio for a small business is, in general, many investors look for a company to have a debt ratio between 0.3 and 0.6. Debt ratios of 0.4 or lower are considered better from a risk standpoint, while a debt ratio of 0.6 or higher makes borrowing money a steeper challenge.
Debt financing of a small business can be structured in the form of 1) short-term loans, 2) a business line of credit or 3) cash flow loans.
A loan with a relatively quick repayment period, a short-term loan is one in which the borrower receives cash in a lump sum upfront, then repays the loan, often with some substantial financing rates. Some short-term loans permit the borrower to make extra payments to pay it off sooner. However, some short-term loans actually come with penalties for early repayment. Short-term loans generally have a term of 12 months or less.
Payments on short-term loans are required frequently â sometimes once a week, or, in some cases, every day.
Although the credit requirements are not as strict for short-term loans as they are for regular term loans, the frequent payment schedule may be burdensome for someone in a new business without a lot of cash flow at that moment. But a businessperson who needs a loan in a hurry still might opt for a short-term loan because it may be easier to secure than other forms of financing.
Business credit requirements are not as strict for short-term loans as they are for regular term loans, but the frequent payment schedule may be burdensome for someone in a new business without a lot of cash flow at that moment. With fewer requirements than longer-term loans, short-term loans from online lenders may be easier to get approval than some other types of loans.
Choosing to apply for a short-term loan comes with the expectation that you might have to repay it over just a couple of weeks. If you have an installment loan, you have up to six months to pay it off. A short-term loan application is completed online and normally takes a matter of minutes to be approved.
Rapid processing is one of the main attractions of a short-term online loan. Sometimes approval could even come the same day the application is placed. In addition to fast approval, other advantages of short-term online loans for working capital include paying less interest, the chance to improve a bad credit rating, and flexibility.
In contrast to a short-term loan, long-term financing is a more appropriate option for larger projects such as purchasing a business, renovations, equipment purchases, or real estate investments.
Business Line of Credit
When a lender provides pre-approved funding with a maximum credit limit, that is known as a business line of credit. If the borrower is approved for this line of credit, funds can be accessed whenever they are needed until the established credit limit has been reached.
Because the borrower is only paying interest on the amount that he or she withdraws, a business line of credit can be advantageous for business owners who are uncertain of the amount of funding they will actually require, or when they might need it.
The drawback to a business line of credit is that the loan will be at a rate that might be considerably higher than other types of loans. How costly that would be is heavily dependent on the amount of funds the entrepreneur ends up using.
If a business owner needs to establish a favorable credit history, a business line of credit could help him or her do that.
In one case, a business owner is approved for a $50,000 business line of credit with a 12% interest rate. Then the owner waits three months prior to making a withdrawal. If he owes no monthly payments during that time, once he decides to make a $20,000 withdrawal, payments are then due for a monthly percentage of the amount borrowed as well as interest. Although repayment terms arenât always the same, one year is a frequently established amount of time. In this case, the $20,000 must be repaid over that time period plus interest. Lines of credit have more flexibility than a small business loan because funds are not disbursed in a lump sum. Also, until you borrow a certain amount, payments are not required.
usiness lines of credit are considered to be revolving debt, comparable to credit cards. That classification enables the borrower to dip into these funds more than once, as long as he has paid back what he originally borrowed.
Lendersâ policies vary, but the ability to withdraw funds from a business line of credit is usually relatively painless and fast. Some lenders with stricter policies in place may require the borrower to reapply for financing each time they draw from the business line of credit, to ensure that their creditworthiness has not changed.
Cash Flow Loans
In the case of a cash flow loan, the small business owner would get an advance of funds based on the revenue he or she is earning. Rather than paying the money back over time with interest, you get the remaining percentage of your revenue, minus the lender’s fees, as your cash flow comes in. Invoice factoring and merchant cash advances both could be considered cash flow loans.
For companies that have unpaid invoices, invoice factoring is a financing method where you sell your accounts receivable at a discount for a lump sum cash amount.
A method of securing working capital that is a little different than applying for a loan, invoice factoring is the process of selling invoices at a discounted rate to a factoring company and receiving in return a lump sum of cash that can be used as working capital.
After assessing the risk of financing the business ownerâs invoice, the factoring company collects payments from the businessâ customers over a span of between one and three months. If a company sells something to a customer, but that customer cannot pay off the invoice right away, thereâs a gap in time that could create a shortfall for the business owner. The lump sum that the business would receive by undertaking the process of invoice factoring would cover the shortfall and solve the problem of cash on hand.
The business will sell the invoice to the factoring company at a 3 percent discount, to account for the factoring fee. This method of securing working capital enables a business to work around the obstacle of a slow-paying customer. Some factoring companies will supply the cash needed for working capital in as little as 24 hours.
Some of the drawbacks to invoice financing for business funding include surrendering control, taking on the potential stigma associated with factoring (which some observers could interpret as a sign that oneâs business is struggling), and the cost (when factoring companies manage the process of collections and the control of credit, it is more costly and the businessâ profit margin takes a hit as a result).
Another way to facilitate access to money needed to finance oneâs business expenses is a merchant cash advance. In this instance, a company grants the borrower access to cash. The borrower is then required to pay a portion of his or her sales made with credit and debit cards, as well as an additional fee.
A merchant cash advance does not require collateral or a minimum credit score. A merchant cash advance can be an expedient way for a business owner to get his hands on capital when the need for cash becomes extremely pressing. A business owner might be slammed with a bill he or she did not expect, or the owner might need the cash fast in order to consummate a time-sensitive deal that must be decided upon sooner rather than later.
With a merchant cash advance, a business owner can potentially get hold of a large sum of funding in a hurry. The turnaround actually could be realized in as little as 24 to 48 hours in some cases. A merchant cash advance could be for a sum of a few thousand dollars up to as much as $200,000 with a minimum of paperwork. The âheavy liftingâ in a merchant cash advance is usually handled virtually.
Repayment of a merchant cash advance is based on the credit card receipts of a business. If the company has had a slow day, the repayment amount for that day is reduced. Funders of merchant cash advances can take 20 percent of credit card receipts on a daily basis. How much a funder takes is tied to a companyâs success more than it is to the calendar.
Companies that provide merchant cash advances do not stress credit scores if the borrower comes into the deal burdened with a less than stellar credit history. Lenders instead will make their decisions based on current operations and sales projections. For a business that endured a rough start financially, but which still anticipates a rosier financial future, a merchant cash advance might be the best option for a fast business loan.
The ease and expediency of merchant cash advances is not free, however. The factor rate, which is a percentage â often expressed as a decimal ranging from 1.1 to 1.9 â that shows how much extra a borrower owes on a loan, carries a high effective annual percentage rate (APR), and repaying it can be a genuine burden on a companyâs cash flow.
Are there advantages to debt?
Debt sounds like a foreboding concept, and, for sure, it can become an unwieldy and dangerous threat to a business if it gets out of hand. But there are benefits to debt financing for a small business owner.
- With debt financing, you need not surrender a stake in your business. You retain full ownership of your company.
- By retaining full ownership of your business, you also have final say in how itâs operated. A lender cannot dictate how you run your company (while a partner can).
- Any interest paid on money that you borrowed for business activities is tax deductible.
- Making on-time payments after borrowing money can help you boost your credit score.
What are the disadvantages of debt financing?
Of course, taking in debt means incurring risk. Here are some of the potential drawbacks to funding your small business on credit:
- Failure to pay off a loan puts the assets of your company on the line. Without enough collateral, you might have to sign a personal guarantee, which potentially exposes your personal possessions to risk.
- Financial growth may be hindered while you are required to make regular payments on your loan every month. If thereâs a variable interest rate on the financing, your cash flow could be jeopardized.
- Unless you have good credit already, it might be hard to qualify for the loan that youâre seeking, or if you are funding a startup company without a track record yet.
- Late or skipped payments can have a negative impact on your businessâs credit rating, making it more difficult to borrow money in the future.
- Even if your business fails, youâre still on the hook to pay off your debt, meaning a worst-case scenario of bankruptcy.
Ultimately, there might be sufficient advantages for a small business owner to have company debt if it means preserving full ownership and control of the decision-making in oneâs company. There are funding sources online that can help a small business owner make informed decisions about debt financing, sources that tailor funding to match small businessesâ needs as they take on an ever-changing economic landscape.