Long-Term Debt Financing
Long-term debt financing usually is used in cases when a company wants to grow by long-term assets 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. If there is a long-term asset, it will be acceptable for lenders to risk long-term financing.
A lender will normally require that long-term loans be secured by the assets to be purchased.
Short-Term Debt Financing
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 a short-term loan because scheduled repayment takes place in less than one year. A line of credit, credit cards, and business overdrafts are examples of short-term debt financing. Lines of credit are also typically secured by assets (or collateral).
Short-term financing is commonly used by businesses that tend to have temporary cash flow issues when sales revenues cannot cover current expenses.
Advantages of Debt Financing
The main advantage of debt financing over equity financing is that the lender does not take an equity position in your business. You retain full ownership and the lender has no control over the running of the business. On the other hand, with equity financing, the investors become part owners of the company and therefore have a say in how the business is managed.
Debt interest costs are fully tax-deductible as a business expense. This is a benefit for companies, interest rate expanse can be written in the company’s P/L analysis and show a clear picture of the company’s real profit.
Disadvantages of Debt Financing
For financing, banks normally require assets of the business to be posted as collateral for the loan. If the business does not have collateral, the lender will require personal guarantees from the business owners. As an owner, this leaves you personally responsible for paying back the loan. If the business is in difficulty and is unable to make the loan payments, whatever personal assets you have posted as collateral (house, car, investment accounts, etc.) can be seized by the bank.
With debt financing, the fixed repayment schedule and the high cost of loan repayment can make it difficult for a business to expand.
Nowadays, debt financing is a very popular source of financing for businesses, as it enables the business to not only meet its working capital requirements but also to expand its business.