Debt Financing

A loan is what we typically think of when Debt financing is mentioned. Debt financing is when a creditor decides to loan funds in exchange for reimbursement in the future with accumulated interest. The creditor does not acquire an ownership privilege in the debtor's venture. Debt financing is generally considered smart because debtors do not surrender any ownership interests in their business. Other reasons debt financing is considered smart are because the financing cost is more or less a fixed expense and interest on the loan is deductible.

Topics a business owner needs to know about debt financing includes:

Selecting a Lender: What are the choices? Where can you find the best loan?
Types of Bank Loans: What kinds of loans are offered? What are the realistic issues for a small business owner?
Costs: What are the costs and burdens of a loan? What are the direct and indirect costs?
Items Banks Look For: What type of credit history, guarantee, and cash flow do banks look for? How does it relate to different kinds of loans? What type of paperwork and documentation will you need to get a typical loan?
Asset-Based Financing: What can your businesses inventory or accounts receivables be used as collateral?
Leasing: Is renting equipment an alternative way to pay for purchases?
Trade Credit: Can suppliers provide your business an alternative to traditional loans?
Insurance Companies: Can your current policy be a source of a low-interest loan?

Selecting a Lender

There are many kinds of establishments that offer loans. Remember that each category of lender may be superior depending on the lending circumstances.

Banks: This category includes conventional savings banks, savings and loans, and larger commercial banks. This is commonly the first place a small business owner looks when searching for institutional financing.
Credit Unions: They usually offer better loan terms when compared to regular banks, but generally make most of their loans to consumers.
Consumer Finance Companies: This category of lender more often than not offers loans that are higher-interest to higher-risk borrowers.
Commercial Finance Companies: This type of financing may be worth taking into consideration if you require a loan for inventory or equipment.

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Types of Bank Loans

The two characteristics that bank loans can be distinguish by are the:

Loan term
Security or collateral required.

Loan term. The "Loan term" is usually the time in length you have to pay off the debt. Debt financing can be considered long or short-term. Long-term debt is normally used for the improvement, purchase, or expansion of fixed assets. Fixed assets are generally the plant, facilities, equipment, and real estate your business will require. If the fixed asset is purchased from the proceeds of the loan, you will typically match the loan duration with the assets life. Short-term debt is frequently a tool that is used to raise funds for inventory, current account due, and for new working capital.

Security or collateral required. More substantial collateral is usually required as security for Long-term financing. The additional collateral helps hedge against the longer risk period a lender has assumed.

Type of debt, secured vs. unsecured. Debt financing comes in two forms, secured and unsecured. As with all loans, a secured loan is an agreement to pay the debt back at a later date. The agreement is "secured" by conceding the creditor an interest in property or assets. If the debtor ever defaults on the loan agreement, then the creditor can recover their money by confiscating the property or asset used to secure the debt. For almost any small startup business, the lenders will almost always require loans to be secured with sufficient collateral.

Loan circumstances and covenants are always mandatory. The value of pledged collateral is critical to a secured lender. A lender will also minimize its risk by underestimating the value of your collateral. They then only loan a percentage of the collaterals appraised value. The loan-to-value ratio is the maximum loan amount, compared to the assessment of the collateral.

An unsecured loan is also a promise to pay off a debt. An unsecured loan differs from a secured loan because you don’t have to grant the creditor interest in any specific property to support the promise. The lender is counting upon the creditworthiness, trustworthiness, and reputation of the borrower to repay the money that is loaned. A revolving consumer credit card is a good example of an unsecured loan. It is possible, but not very likely that working capital lines of credit can also be unsecured.

The downside for the lender is the possibility that the borrower could default on an unsecured loan. If a default occurs, the creditor has no claim or priority against any particular property of the borrower. In instance of a default, the creditor can try to attain a monetary judgment against the borrower. Small businesses can’t usually get unsecured loans until it has established a positive credit history. Small businesses that don’t have a proven track record are generally considered to risky for unsecured credit.

In the case of bankruptcy, the unsecured creditor is frequently the last to be paid if the borrower runs into difficulties. When a debtor files for bankruptcy, the bankruptcy court will usually discard an unsecured loan. After bankruptcy, no assets usually remain to pay off the debts to the low precedence creditors.

Different types of bank loans. The general types of loans given by banks for startups and emerging small businesses are:

Credit Cards: These are usually high-interest and involve unsecured revolving lines of credit.
Short-Term Commercial Loans: Typically for one to three years in length.
Longer-Term Commercial Loan: These are normally secured by an asset such as real estate.
Working Capital Lines of Credit: This type of loan is generally used to satisfy the ongoing cash needs of a business.
Equipment Leasing: Typically used to purchase assets you don't want to buy.
Letter of Credit: Satisfies the need of businesses that conducts international trade/commerce.

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The True Cost of Borrowing Money

Borrowing money often costs and involves more than just the interest rate. An assortment of other costs should be considered in determining the real cost of borrowing money. The costs can be both monetary and non-monetary. For example, a non-monetary cost would be a loan that requires you to maintain financial ratios even though they are unrealistic for your particular business. A good checklist for examining the true costs of borrowing money should include:

The direct financial costs: Interest rates, points, penalties, and required account balances.
The indirect costs: Periodic financial reporting, maintenance of certain financial covenants, and subordination agreements
The loan conditions: How long is your loan? Is it a fixed or variable rate? Do you have to pay an administrative fee or points?
Personal guarantees: For a small or starting business, this is usually needed to obtain the loan.

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Items Banks Look For

Banks typically look at the same information no matter if you are applying for home equity credit, a line of credit for business working capital, a commercial short-term loan, an equipment loan, real estate financing, or some other type of commercial or consumer loan. The minimum essential characteristics a potential lender will want to research are:

The Credit History of the borrower
The Cash Flow History and future projections of the business
The Collateral available to secure the loan
The Character of the borrower, including past business experience and history.
All Loan Documentation including business and personal financials, tax returns, and more than likely a complete business plan. The Business plan should summarize and provide evidence for the credit history, cash flow history, collateral available, and character of the borrower.

The credit history, cash flow history, and collateral available are fundamentally objective data, but the interpretation of these records can be considered subjective. The last item, the character of the borrower, permits the lender or loan officer to make a more individual assessment of the business's consumer appeal and the business experience of the owners. Lenders are often willing to take into account individual factors that represent strengths or weaknesses for a loan. These factors can play a big part in the evaluation of whether or not a small business gets financed.

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Asset-Based Financing

Asset based financing is primarily used to get cash for working capital or to meet specific short-term needs. Businesses could use certain short-term assets (such as inventory or accounts receivables) as collateral for the loans. The three most common forms of asset-based financing are:

Accounts Receivable Financing: This financing uses the accounts receivables as collateral for the loan. When the accounts receivables are collected, the money is immediately used to repay the debt.
Inventory Financing: This is very similar to accounts receivable financing except it uses inventory as the collateral for the loan.
Factoring: The process where the accounts receivable are actually sold for a discount price. The party who purchases the accounts receivables takes on the job of collections.

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Leasing

Small businesses can rent equipment or assets from leasing companies, some banks, and certain suppliers or vendors. A number of manufacturers have leasing agents whose specific job is to orchestrate lease terms or credit arrangements. The arrangements are usually with the coordinated through a manufacturer, subsidiary company, or specific leasing agent.

Leasing assets is largely considered a type of financing. By leasing assets you avoid the large down payment often required for purchases and you free up funds for additional expenditures. Your business ought to be conscious that leasing is not easy for startup businesses because most of the traditional lenders want an operating history from applicants. Some of the advantages of leasing are:

Leasing frees up cash: Some leases require a small or even no down payment. Leasing permit you to target cash toward other expenses or investments. All small businesses or startups will benefit from an improved cash position, which will increase your capacity to acquire other debt.
Leasing will cause less debt to appear on your financial statements: In a straightforward lease you rent assets for a set time period without permanent ownership. The leased asset and the cost of leasing will not show up on a balance sheet. Lease amounts will only show up on the cash flow and expense-related financial statements as they come due. Having a lower level of debt will enhance your chances for future loans.
Allows more flexibility for equipment changes and upgrades: Any business in a changing industry where technology changes or new equipment is common will benefit from leasing because it allows you to minimize the costs of purchasing equipment that can become outdated. Additionally, many leasing companies offer lease upgrade options or termination fees. Businesses usually have the option to purchase an asset at the end of the lease term.
Tax deductible: Leasing is a deductible expenses that instantly decreases income that is taxable. Lastly, the benefits of a lease deduction should be compared to the depreciation deduction your business would obtain if the asset were purchased.
Landlord may help: Sometimes the landlord may be agreeable to pay for improvements to the property that is necessary for your business. This usually takes a long-term lease for office or plant space. The improvements are paid for through a deduction in the rent over the life of the lease. This agreement will save cash and equity. It also does not weaken your financial ratios for any future financing your business may need.

There are also a number of disadvantages of leasing.

More and more businesses are using leases. This has triggered a greater resourcefulness in terms of leases. Leases are commonly composed so they bear a resemblance to a long-term acquisition of capital equipment. The term of the lease always estimates the expected useful life of the asset. The core lease payment is directly related to the cost of the asset. The lessee is typically responsible for paying the insurance and related taxes on the asset. There is not usually an obligation to purchase the asset at the end of the lease, but a purchase option may be, and usually is, available at the end of the lease. The purchase price is stated in the terms of the lease agreement. Additionally, a service contract can usually be obtained for an extra cost.

If your ownership rights escalate in a lease agreement, you might need to show the lease on the financial statements as an asset. This would include a listing of the asset and a liability for the sum of the "loan." This change will have a negative effect on your financial ratios.

Sales and leasebacks. This is a form of lease financing that necessitates the borrower to sell their valuable assets, such as equipment, to a financier. The financer then leases the equipment (or other asset) back to the seller. The sale can create needed cash to the business for a short-term need. This process allows the continued use of the asset while creating a tax deduction for rental expenses. This form of lease financing usually contains a purchase opportunity at the end of the lease period. This allows the borrower a chance to reacquire ownership of the asset at a later date.

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Trade Credit

Through the use of trade credit, a businesses suppliers and customers can represent possible sources for financing through a variety of different options.

The basic term for a buyer's purchase of supplies from a vendor or supplier who finances the purchase by postponing the date at which the purchase price is due, or allows payment by installments is called "Trade credit". It is common for vendors and suppliers to be willing to sell on credit. This is a source of capital financing that is common for startups and expanding businesses. Suppliers understand that almost every small business relies predominantly upon a limited number of suppliers. Small businesses by and large represent a small risk if a supplier can keep a firm grip on the credit terms and receivables. Many suppliers are counting on small businesses for future sales.

Startup businesses can gain by looking for potential suppliers as soon as a business location is selected. Most new businesses rely a great deal upon a single supplier. If this is the case, it is usually easier to reach a long-term arrangement regarding credit. Once you select a location, offer a proposal to a number of potential suppliers that fit your needs. Make sure to give a rough idea on how much inventory you will need to get started and how much you will buy from the supplier in the future. The future demand should be consistent with the sales projections made in your business plan.

Any business that utilizes trade credit should expect a supplier to require priority security interest for all goods provided to you on credit. It is possible that they go one step further and require that you personally guarantee the purchase price of the initial inventory. These terms are flexible and the more business you do with a supplier, the better your negotiating position for arranging additional credit purchases.

Making payments from current cash flow is the critical factor when managing the amount of trade credit and other debt your business assumes. The length of time and repayment amounts are important in relation to incoming cash sources. Creditors are looking for practical cash flow projections and a good cash flow history.

The major advantages of trade credit are:

It is usually readily available.
Payments get spread out over several months or years
There is usually a minimal or no down payment required.
Little or no interest charges are levied.

Trade credit can be as simple as a delay in the required payment for purchases, sales on consignment, equipment loans, or a variety of other options. These all assist dealers in financing purchases. An example of this would is a supplier who agrees to an arrangement where you to pay for specific items only as they are sold. In this arrangement, the supplier will retain ownership of goods until they are paid for. This arrangement also allows the supplier to continually monitor the merchandise at your store and the ability to adjust quantities with current changes in demand.

Buying on consignment is a financing option in several industries. The items commonly associated with buying on consignment are retail print products, electronic consumer goods, and furniture. Purchasing on consignment means that you pay the supplier for items only if they are sold. The supplier retains the title for the goods. When they are sold, you keep a percentage of the sale and send the remainder back to the supplier for payment of the item. This is a relatively risk free way for you to do business because there is upfront inventory cost, and if you don't sell it you just return it to the supplier with nothing being paid out of your pocket.

The hidden cost to use trade credit is usually a higher purchase price. Vendors often experience the same cash flow problems as small businesses. To relieve their own cash flow problems, vendors will typically offer a discounts for an immediate payment. When you purchase goods on credit, you sacrifice the discount and end up paying a higher price. It's a good idea to learn when there is and advantage on when to take a trade discount.

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Insurance Companies

If you have considerable cash in a life insurance policy, you can typically have access to part of the amount from your insurer. Normally, you would first have to borrow against the insurance policy and then re-lend the funds to your business at the same rate. Your business will receive an interest deduction on the loan, helping to reduce its taxable income, and you personally do not earn any taxable interest income. When you borrow against your personal insurance policy, you are only required to pay the interest on the loan and not the loan principal. Interest is typically due annually, on the anniversary date. Many insurance policies will let you include the accumulated interest with the principal. This is usually the case if you have not borrowed up to the cash surrender value of the policy. The interest rate depends upon when the policy was purchased. Many older policies have rates that are very favorable. However, when you borrow against your own life insurance policy the ultimate death benefit will be reduced by the amount of the loan, plus the loss of any accumulated interest.

Insurance companies are not customarily a practical source of financing for a small business. Even though insurers enthusiastically search for investments for unused premium income, the companies they invest in tend to be established businesses. Insurance companies sometimes offer limited possibilities for available security, such as real estate. Insurance companies generally make secured term and mortgage loans. When you borrow from an insurance company, you can anticipate similar terms and interest rates offered by a commercial bank. In summary, insurance companies can usually provide a large amount of capital at competitive interest rates, but you typically need enough assets to cover the debt.

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