Raising capital for your business can seem like climbing a hill backward, but it’s doable. Learn about debt financing and how to raise the funds you need.
The writing’s on the wall – around 82% of businesses across the United States go under due to poor financial management.
Starting and sustaining a business is all-consuming, and when it fails, you can feel gutted. Your cash flow is the lifeblood of your firm and is likened to a glass ball. When issues such as a breakdown in working capital harm your cash flow, it’s tough to repair the glass ball.
Thus, many firms end up seeking debt financing as a means to fund their working capital needs and maintain proper cash flow. Here’s a guide on how to use debt to finance your working capital.
What Is Debt Financing?
Financing using debt is when a business sells debt instruments to institutions and/or individuals in return for money.
The funds can go to supporting working capital or other capital expenditures.
In return for taking up the debt instruments, the investors receive a promise of repayment on the principal and interest.
How Raising Finance Through Debts Works
When a business needs to bring in external capital, it typically has three options to consider. These are equity financing, debt, or a combination of the two.
With equity, you sell an ownership stake to an investor in return for an agreed sum. Since the investor becomes an owner, they gain the right to claim earnings from future revenue.
Equity financing doesn’t need to be paid back. In case the firm goes under, such investors will receive their money last after creditors.
In stark contrast, debt capital is premised on the debt instrument that you sell. These instruments include bonds, bills, or notes.
Once an investor holds fixed-income security you’ve sold them, you will need to pay them back at an agreed date.
However, such an investor doesn’t get to claim any income from your firm’s future earnings once you finish paying the principal and interest.
In case the organization goes under, an investor holding a debt instrument stands to receive their money before those holding equity.
Benefits of Financing Working Capital Through Debt
Several essential reasons would drive you to consider funding your working capital through debt. These include:
- Retaining Ownership
One standout perk of using debt to fund your working capital is that you don’t give up ownership of your firm.
An investor who comes in through debt instruments can only expect you to repay the principal and the agreed-upon interest. Once that is satisfied, you are free and clear from further obligations.
- Improve Your Business Credit History
Using debt to keep your working capital running has the secondary benefit of building your firm’s credit profile.
As you take on appropriate debt, watch your debt utilization level, and repay promptly, your firm can gain a positive track record.
That has the net benefit of enabling you access financing at lower rates in the future.
- Tax Deductions
In many instances, you can categorize the interest tied to business debt finances as expenses. As such, when tax time rolls around, you can deduct the interest from your business income taxes.
Types of Debt You Can Use for Financing Working Capital
Any firm looking to raise working capital through debt has several options to consider on the market. However, each option best serves a particular dynamic, and it’s up to you to look at what source of debt could be the best fit for your firm.
Let’s look at some of these sources.
1. Business Line of Credit
A business line of credit is where a lender gives you a credit facility with a limit. When you need the money, you can withdraw from the line of credit until you max out the limit.
The facility can either be revolving or fixed. When you opt for a revolving one, you can pay a portion of the facility and borrow again up to the repaid amount.
If you’re in the market for debt that can help you cushion your cash flow so that you better structure working capital, then a line credit may work for you.
2. Term Loans
A term loan enables you to get a specific amount from a lender upfront and later on repay it with interest over an agreed repayment schedule.
Various lenders offer term loans, but banks tend to provide the best rates. With that said, you will need to meet stringent eligibility standards and give yourself adequate waiting time for the financing.
When it comes to working capital, term loan financing is best used if you plan to invest for the long-term. If you have an on-going need for working capital, you can also leverage a term loan successfully.
3. Debtor in Possession Financing
For firms undergoing a chapter 11 bankruptcy, debtor in possession (DIP) financing helps them retain asset control during restructuring.
With DIP, the court authorizes you to obtain more funding from lenders as you restructure. Such a lender then gains senior priority with respect to any liens and security interests in the firm’s asset.
Since the bankruptcy court’s jurisdiction supports the lenders, other creditors who have senior priority pre-bankruptcy are usually comfortable agreeing to this arrangement.
The assets will act as security for the post-bankruptcy lenders who can opt to convert the facility into equity or a long-term credit facility once you emerge out of bankruptcy.
Interest Rates and Debt Finance
Debt lenders and investors have different motivations. You, therefore, must identify what your debt funding source places a priority on. Some will make protecting the principal the main thing. Others are interested more in the interest payments.
Regardless of the goal, lenders will structure the transaction to favor their objective.
High debt funding rates imply you’re a high-risk borrower. Conversely, low-interest rates signal confidence in your ability to repay the debt.
Aside from paying back the interest, you’ll need to abide by other requirements. Many lenders/investors will ask you to meet specific rules for financial performance. These are known as covenants.
Leverage Debt to Keep Your Business Going
Many businesses go under due to improper financial management. How well you handle your cash flow is critical, and thus, your working capital needs to operate optimally. If you don’t have internal funding sources to straighten out your working capital breakdowns, you can lean on debt financing to get you back in the game.
Are you focused on enhancing your firm’s financial position? Check out more of our content for financial tips and insights that help grow your business.