Article

Debt Financing
February 01 , 2013

Debt financing is basically money that you borrow to run your business.

Debt financing can be divided into two categories, based on the type of loan being sought: long term debt financing and short term debt financing.

Long Term Debt Financing usually applies to assets the business is purchasing, such as equipment, buildings, land, or machinery. With long term debt financing, the scheduled repayment of the loan and the estimated useful life of the assets extends over more than one year.

Short Term Debt Financing usually applies to money needed for the day-to-day operations of the business, such as purchasing inventory, supplies, or paying the wages of employees. Short term financing is referred to as an operating loan or short term loan because scheduled repayment takes place in less than one year. A line of credit is an example of short term debt financing. 

Sources of debt finance

Commercial banks offer the greatest variety of loans, although they are conservative lenders. Typical short-term bank loans include commercial loans, lines of credit, discounting accounts receivable, inventory financing, and floor planning. 

Trade credit is used extensively by small businesses as a source of financing. Vendors and suppliers commonly finance sales to businesses for 30, 60, or even 90 days.

Equipment suppliers offer small businesses financing similar to trade credit but with slightly different terms.

Commercial finance companies offer many of the same types of loans that banks do, but they are more risk oriented in their lending practices. They emphasize accounts receivable financing and inventory loans.

Savings and loan associations specialize in loans to purchase real property - commercial and industrial mortgages - for up to 30 years. 

Stock-brokerage houses offer loans to prospective entrepreneurs at lower interest rates than banks because they have high-quality, liquid collateral - stocks and bonds in the borrower's portfolio. 

Insurance companies provide financing through policy loans and mortgage loans. Policy loans are extended to the owner against the cash surrender value of insurance policies. Mortgage loans are made for large amounts and are based on the value of the land being purchased.

Debt finance risks

Risks of Losing Collateral

In getting your business loan or line of credit, you may have to pledge some of the company's valuable holdings -such as real estate - as collateral. Whatever you pledge as collateral becomes subject to seizure by the lender if you default on your debt. If this happens, it could cripple the company's operations.

Risks to Your Credit Rating

If you incur a debt to fund a business expansion and then default on that debt - or just make a few late payments - it could dramatically lower your company's credit rating. If that happens, it becomes much more difficult to raise money in the future, since lenders look at your credit rating to determine creditworthiness. Since access to credit is important to business growth, failing to make payments can hobble your business's ability to grow in the future.

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