When it comes to funding a business, capital is paramount. Capital is the operating money that you need to get your business running smoothly before you start bringing in money to break even and eventually turn a profit. There are two types of capital: equity and debt. Equity and debt are very different and will have different bearings on your business so it is important to understand your business needs and the type of capital that will work best for you.
Debit finance is more commonly referred to as debt finance and is a way of raising capital for a business, usually a start-up, with a specific type of loan. Debit financing does not require investors which makes it preferable for some businesses, but it requires repayments at set times so it can also be a liability if you don’t fully understand what you are doing.
Typically, debit finance is a loan secured against an asset. This gives the lender assurance that they won’t lose money from the deal because they can claim the asset if the loan is not repaid according to the deal agreement. Common assets used in debit finance include property, vehicles, or equipment, depending on the size of the loan.
In addition to putting up an asset as collateral, you will also be required to pay interest on your loan and pay it back within a set timeframe. Interest can be fixed or floating, depending on your lender and the terms of the loan. The one advantage here is that because there is an asset tied to the loan, interest rates are usually lower.
In some cases, capital is not the problem, but operating costs are. Some more established businesses will also use debit finance to help them with daily operating costs when they have cash flow problems. This is the preferred method over overdrafts for handling long-term debts as well where repayments are likely to take months rather than weeks. It is more secure for lenders because of the asset attached, and there are usually lower interest rates for the business.
Why is it called debit financing?
A debit is an accounting term for any payment associated with the purchase of assets or an expense. Debt is money that is owed and needs to be paid back – often with interest. Debit financing is usually called debt financing because it requires repayment and incurs interest. But it can also be referred to as debit finance because it is directly linked to business assets.
Examples of debit finance
Debit finance comes in many different forms, from peer-to-peer loans to traditional bank loans.
Traditional Bank Loans
These are becoming harder to find for small and new businesses as banks and building societies start to handle their risks differently. There are a lot of requirements that banks have in place for debit finance and they are more likely to lend money to established businesses where they have a higher guarantee of return. Banks often also put in place guidelines for the type of loan they are giving. That could mean the money is earmarked for equipment or salaries, but you need to be able to show that the money has covered the intended expense.
For sole traders and partnerships, you may be able to get a personal loan. There is a risk here as you will need to put up personal property as collateral against the loan and if you are unable to make payments you risk losing personal assets.
Family and Friends
If you are lucky enough to have friends and family with deep pockets, family and friends loans could be a good choice. Loan terms are usually looser and you are more likely to be able to negotiate terms if you need to.
However, there is significant risk associated with loans from friends and family. Borrowing from a lender means you borrow money from someone who fully understands the risks, and if you can’t repay them for any reason, there is no damage to an existing relationship. When you borrow money from people you know there is the risk of them not fully understanding the risks they are incurring. You must factor in that if you are unable to pay them back you could lose a relationship.
If you choose a family and friends loan it is vital to have a written and signed agreement in place to protect both you and them. You should also make sure you explain exactly what the loan is for, the terms of repayment that are expected, and the risks that are involved.
Peer-to-peer lending is common these days for new businesses, especially businesses that are niche or are based on ethical values. Websites like KickStarter, Prosper, and GoFundMe allow lenders to give to businesses that they believe in.
This is not a true form of debit finance as there is no risk to the business and no collateral attached. But if a business can’t produce the service or product that has been promised, they risk losing a global reputation and following, meaning it could be almost impossible to get the business running again.
Home equity loans
Home equity loans work in a similar way to a mortgage in that you are expected to pay the same amount on a regular basis including interest repayments. The loan is secured by your property so there is usually a lower interest rate, but this puts property at risk should you find yourself unable to pay.
How does debit finance work?
Debit finance is typically divided into two categories: long-term loans and short-term loans. The type of loan you get depends on your needs and you will need to factor in what the loan is specifically for, how long it will take to repay the loan, and what kind of interest you are willing and able to pay.
Long-term debit finance
Businesses are likely to choose long-term debit finance if they need to purchase larger items like property, vehicles, equipment, machinery, or buildings. These loans are often secured against the item that is being purchased and terms of repayment are longer, usually lasting between three and seven years.
Long-term loans are usually predictable in their repayments with a fixed interest rate and payment made for the same amount and at the same time each month. This makes budgeting easier as you will always know what money needs to come out of your account every month to repay the loan. Making these regular payments can also increase your credit score and improve your chances of borrowing again in the future.
Short-term debit finance
This type of financing is usually used to combat cash flow problems and help businesses with basic operating capital. Small payments or purchases such as wages, inventory, or bills might be covered by this type of loan if the business knows there will be income in the following months to cover the borrowed amount.
Short-term debit finance usually has to be paid back within a year and is usually secured against a smaller asset that the business owns. It is a lot more popular for smaller businesses and start-ups because it helps with temporary cash flow problems and is a debt that can be resolved within a year rather than several years.
What to think about before debit financing
Before you decide to finance your business with debit rather than equity, there are important considerations that you need to make to decide if this is right for your business.
You will need to consider the cost of debt to your business against the cost of equity. The cost of debt will be interest and repayments on the loan while the cost of equity will be dividend payments to shareholders. Comparing what will be owed in each case will help you decide which form of financing is more feasible and profitable for your business in the long run.
Remember to factor in any tax deductions you might be able to make on things like interest on loans as this could make a difference to your bottom line as well.
You will also need to carefully consider the interest rates of various lenders and what they are offering you. Although most lenders will stay within a certain interest bracket based on market rates and your credit score, you may be able to find a lender with a lower rate, or one with better terms for long-term loans. On a longer term loan you might want to look for fixed interest rates to ensure you have fixed payments for a few years.
Remember that just because a lender has better interest rates does not mean they are a better choice for your business. Check all the legal terms and conditions and make sure you borrow from a reputable source.
What are the advantages of debit finance
If you are still trying to decide if debit finance is right for you, it may be time to weigh up the pros and cons of borrowing against assets.
One of the biggest advantages and a reason a lot of businesses choose debit finance is that you remain in sole command of your company. You will not have to report back to shareholders or share profits with other stakeholders. Knowing that you will take home all the profits from your business can be a big draw for debit finance over equity finance.
Interest on loans is also tax-deductible as a business expense. This means lower taxes on your business and, if you have a long-term loan, reduced monthly expenses. If the interest is fixed, it also means budgeting is more straightforward. You will know exactly how much you need to repay every month and can easily budget the repayments and ensure they are always up to date; paid in full and on time.
Timely payments of debit finance loans can also help to build your business’ credit score, making borrowing in the future a lot easier. A good credit rating will also make your business look more appealing to future investors if you choose to go that way in the future.
Long term debit finance also offers greater stability to a company because the terms are clear and the loan spans many years. Interest rates are typically lower than on short-term loans and overall the loan is likely to work out cheaper.
What are the disadvantages of debit finance
There are also distinct disadvantages to choosing to finance your business through debt rather than equity.
As already stated, you will need to put up collateral against your loan so that the lender has security that they won’t lose money. For bigger businesses this might not be as much of a problem, but for small businesses where there are not a lot of assets, many lenders will expect personal assets to be used as collateral. Personal guarantees put you directly at risk rather than only risking your business.
Risk associated with personal guarantee carries to incorporated businesses as well and doesn’t only apply to sole traders and partnerships. You will need to be prepared to lose your car, house, or other asset you put up as collateral in the event of not being able to pay back the loan with business income.
You will also need a proven track record for most lenders to consider you for a loan. That means your business usually needs to be more established and needs to have built up a credit score before you can even apply for a loan.
Fixed repayment schedules, especially on long-term loans, can also be a disadvantage to certain businesses as they can prevent businesses from growing. If you are constantly trying to catch up on repayments it is harder to focus on turning a profit and difficult to build up lump sums of money that can be reinvested in the business.
You will need to be extremely disciplined with your money to ensure you make your payments on time. If you become too dependent on debt then you may be seen as a high risk company and find that fewer lenders will give you loans in the future.
Finally, if your business is bigger you will also need to consider how much money you are able to borrow. Often, debit finance is offered in lower amounts than you are able to get as equity finance, which means you may not be able to completely cover the costs you are budgeting for.