CHAPTER FIVE: Part B – There are always two sides to a coin; and for every action, there is an equal and opposite reaction. The same is also applicable in business especially when it comes to taking critical management decisions.
Now with respect to debt financing, there is an advantage; as well as a corresponding disadvantage. This article will highlight in detail, the pros and cons of using debt to finance a business.
Top 10 Advantages and Disadvantages of Debt Financing
- You still have full control over your business
Although the lender will charge you interest for using the loan, they won’t have any say in how you run or manage your business. The ownership of your business stays fully in your hands. Though you may lose some of your tangible assets if you are unable to repay the loan, you won’t lose strategic control of your business; provided you legally protected your personal assets. I recommend you seek the advice of a corporate attorney and accountant for better information on asset protection.
- The lender won’t be entitled to any of the profits you make from your business; all you have to do is repay the loan within the fixed time frame.
- You can typically deduct interest payments (but not principal repayments) as a business expense.
- The interest you repay on your loan is tax-deductible. This means that debt financing shields part of your business income from taxes and lowers your tax liability every year. Your interest is usually based on the prime interest rate.
- Taking on debt can build your business credit, which is good for future borrowing and for insurance rates.
10 Disadvantages of Debt Financing for Small Businesses
- You will have to pay interest, which is usually carried as a liability on the company’s balance sheet.
- Since you will borrow money to run your business, you may end up committing your business to a large business expense.
- You may be under pressure to repay the loan with cash that you need badly for some other aspects of your business. In such a situation, your business suffers; and it may never recover!
- If you get loans from family or friends and have problems repaying it back or keeping up with the payment terms, this can ruin your relationship with them; temporarily or permanently.
- If you borrow from a bank or commercial lender, you will be required to pledge your property as security for the loan. (If you don’t repay the loan, the lender can take the property and sell it to recoup the money). If you pledge business assets as security for the loan, and you are unable to pay back, you may lose these assets when you need them the most. Worse, if you pledge personal assets, such as your house or stock portfolio, then you risk losing them to pay a business debt.
- Getting a business loan is always very difficult if you don’t have good credit rating and track record, solid financials, and collateral.
- Debt financing can be too expensive for small businesses because of the risk / return tradeoff.
- If you carry too much debt you will be seen as “high risk” by potential investors; which will limit your ability to raise capital by equity financing in the future.
- Debt can make it difficult for a business to grow because of the high cost of repaying the loan (due to compounding interest).
- You are running the risk of bankruptcy. The more debt financing you use, the higher the risk of bankruptcy.
Now that we have analyzed the advantages and disadvantages of debt financing for small businesses, let’s no conduct the same analysis on equity financing.