The Pros and Cons of Debt Financing in The Early Phase of Business

The world runs on debt. The modern economic system functions around it. Whether you like it or not, our financial structures are driven by the accumulation of debt. 

Businesses often require three key factors for success; resources, strategies and funds. The first two are crucial components, but funding is arguably the most vital of them all, especially when inadequate cash flow is a leading cause of business failure in the early stages.

Viable financing options exist, and debt financing is a popular choice in many countries (including Singapore). So, what are the benefits and how do they stack up against the consequences?

What is debt financing?

The essence of debt financing is pretty self-explanatory - it's a means of financing your business through the act of borrowing money that must eventually be repaid, or in layman terms getting working capital from financial institutions or alternative lenders.  On top of this, you have to pay back your debt loan with a vested amount of interest.

While the bank would be the most conventional choice for attaining debt financing, it's also not uncommon for founders to raise funding from friends, family and relatives as well as from alternative sources like local funds, peer-to-peer lenders, financial initiatives and programs from non-financial sources. Small business bank loans, credit lines and credit cards are all typical forms of debt financing.

It's often compared to equity financing

Like most countries, SME financing in Singapore can be a tricky path to business sustainability. It's riddled with inconveniences, fine print traps and other barriers that stop small businesses from achieving financial stability. 

Many business owners consider the option of debt financing (which is often compared to the process of raising capital through equity). 

The major difference between the two is that equity financing essentially requires that you give up partial ownership of your company. On the other hand, debt financing lets you keep ownership in its entirety, in return for principal payments coupled with interest. It's a pretty tough decision to make, and there are several pros and cons when it comes to taking on debt.

Pro: Fees and interests could be tax-deductible

What often comes to mind are the high-interest rates related to taking on debt, but it's actually possible that debt financing helps to curb additional taxes if the costs of business debt are classified as a business expense. It's one of the more difficult concepts to grasp about debt financing mechanics, but it's a valuable factor to note all the same. 

Let's say that your bank charges you 10% interest on a business loan you just applied for, and the government proceeds to charge about 30 per cent tax rate on top of the interest. 10 per cent of interest multiplied by (1-30 per cent) will lead to about 7 per cent. After the tax deductions, you only have to pay a 7 per cent interest rate instead of the original 10 per cent. Many business owners have benefited from this financial move. You get to obtain the extra cash needed to grow your business while reducing tax rates at the same time.

Pro: You maintain full ownership of the business

As mentioned, this is a big difference between equity and debt financing. While it's common for many founders to seek help from angel investors for their growing business, it's clear that a certain level of control will be shifted with regard to direction and course of action. Whether or not you are comfortable with the looming sense of outside interference from investors, is up to you. 

However, many founders have opted for debt instead of equity financing for this reason alone. It makes more sense to leverage on debt by borrowing from banks or utilizing other types of alternative lending and agreeing to pay funds back according to a certain timeline. Banks will charge interest on what is owed, but that's the trade-off for keeping full ownership.

Pro: There are no lasting obligations

Debt financing is a consistent expenditure, with borrowers having to pay instalments and incur interest along the way. However, your debt is eventually paid off and there are no lasting obligations of any other strings attached by then. As regular monthly payments are made, the overall business budget is gradually improved as the principal gets closer to being paid in full. Once this debt responsibility shrinks and eventually disappears, your business would have grown without any immediate consequences that follow.

Con: SMEs may need asset-based safety measures 

Consider the late-stage growth approach to building a company (in which founders seek to cultivate a venture-backed company). This approach is currently popular. Down the line, all the management and operational structures are in place. Products and services have been tested and proven with a place in the market, and the business is positioned for exponential growth. 

The founders seek funding so that they can acquire customers and capture market share quickly. This means that while profitability may be visible from a margin perspective, the company itself continues to be unprofitable due to necessary investment in marketing, research, production capacity and more. 

These companies are also usually "asset-light", which means that there is very little hard collateral in the form of inventory, machinery, equipment or accounts receivable. Due to this, debt financing may be a risky move, with little ability to support such a financial obligation. We see this issue come up with many tech companies. Try to ensure you either have enough assets to protect your business during debt financing programs or establish alternative measures for better odds at longevity.

For this very reason, some lenders have made collateral a compulsory condition, so that if the loan were to default and the borrower can't pay off the debt, lenders have the ability to acquire and sell off assets as a re-compensation move.

Con: Interest rates may be higher than expected

While it's true that certain taxes may be deductible with debt financing, it's no secret that interest rates can be quite high. This is because interest rates are often determined by risk instead of need. Lenders are essentially also taking a risk by giving out cash, which means that they want some form of reassurance for their efforts. 

This means that interest rates could be extraordinarily high for businesses with a poor credit history or if the group that holds ownership has issues with its history of repaying obligations. In this case, it might be counter-intuitive for companies to opt for debt financing.

Thus do consider using Smart-Towkay.com if your company is looking for debt financing as we help SMES to get a cheaper interest rate regardless of your company financial standing. (u link to article lor)

All debts must eventually be paid 

While we're on the subject of debt and risk, it's worth mentioning that debts have to be paid back eventually. It might sound obvious, but this is a common difficulty faced among many debt-financed individuals or businesses. Soliciting money through investors might have its issues, but at least there's no need to raise funds to pay lenders back. However, debt financing requires borrowers to pay up (whether they have the money or not).

If business is bad, and revenue is insufficient, you'll still be responsible for paying back the debt incurred. Even a bankruptcy proceeding against your private limited company isn't enough to free you from this obligation. Debt may be restructured, but it's a thorn that will always be there until the issue is resolved.

Learn about the differences between debt and equity financing, as well as the pros and cons of debt financing when it comes to financing in the early stages of your business. Tax-deductible fees, ownership, and asset-based safety measures are some points to consider.

Smart-Towkay makes it easy for SMEs to simplify and find alternatives for their business banking needs that are most suited to their business profile. 

Learn more at https://www.smart-towkay.com/

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