Debt Financing

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Editor: Virgil L. Burton, III
Date: 2017
Encyclopedia of Small Business
From: Encyclopedia of Small Business(Vol. 1. 5th ed.)
Publisher: Gale, part of Cengage Group
Document Type: Topic overview
Pages: 3
Content Level: (Level 4)

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Debt Financing

A business can finance its operations through either equity or debt. Equity is cash paid into the business by investors, of whom the business owner is usually one. Investors receive a share of the company, in effect a percentage of it proportional to total investment paid in. The share or stock may appreciate in value in proportion to the increase in the business's net worth—or it may evaporate to nothing at all if the business fails.

Investors put cash into a company in the hope of stock appreciation and the yield of dividends that the business may (but need not) pay to the investor. Dividends are a portion of the net profits of the business; if the business does not realize a profit, it cannot pay a dividend. The investor can get his or her investment back only by selling the share to someone else. In a privately held company, investors have less liquidity because the shares are not traded on the open market and a purchaser may be difficult to find. This is one reason successful and rapidly growing small businesses are under pressure by stockholders to “go public”—and thus to create an easy way for investors to cash out.

Debt financing, by contrast, is cash borrowed from a lender at a fixed rate of interest and with a predetermined maturity date. The principal must be paid back in full by the maturity date, but periodic repayments of principal may be part of the loan arrangement. Debt may take the form of a loan or the sale of bonds; the form itself does not change the principle of the transaction: the lender retains a right to the money lent and may demand it back under conditions specified in the borrowing arrangement.

Lending to a company is thus at least in theory more safe, but the amount the lender can realize in return is fixed to the principal and to the interest charged. Investment is more risky, but if the company is very successful, the upward potential for the investor may be very attractive; the downside is total loss of the investment.

DEBT-TO-EQUITY RATIO

The character of a company's financing is expressed by its debt to equity ratio. Lenders like to see a low debt-to-equity ratio; it means that much more of the company's fortunes are based on investments, which in turn means that investors have a high level of confidence in the company. If the debt-to-equity ratio is high, it means that the business has borrowed a lot of money on a small base of investments. It is then said that the business is highly leveraged, which in turn means that lenders are more exposed than investors to potential problems. These relationships ultimately highlight a certain ambiguity in the relations between lenders and investors: their aims are in conflict but also in mutual support. Investors like to use a small investment and leverage it into a lot of activity by borrowing; lenders like to lend a small amount secured by a large investment. In usual business practice these motivations result in a negotiated equilibrium that shifts this way and that based on market forces and performance.

CASH FLOW-TO-DEBT RATIO

The cash flow of a company in relation to its debt serves lenders as another way to measure whether or not to provide debt financing to a business. A company's profitability, as measured on its books, may be better or worse than its cash generation. In calculating cash flow, only actual cash coming in and going out in a given period is used to calculate net cash available for servicing debt.

The sales of a company for a given period, for example, may be considerably higher than its cash receipts. The reason for this may simply be that the company's customers pay late or have extended payment arrangements. Similarly, the costs of a company, as recorded on its books, may be lower than its actual cash payments in a period. The company, for instance, may be prepaying insurance for the next six months this month; its books will only show one-sixth of that payment as cost but six times as much going out as cash. For these reasons, a company may be profitable based on its books but may be short on cash at any given time. Lenders therefore like to look at the amount of cash available to service the current portions of any new debt. If this amount is minimally 1.25 times the debt service required, the business is at least in the ballpark to receive a loan. The higher this ratio, the more inclined the lender will be to lend.

Rules of thumb along these lines are subject to adjustment based on the availability of money. The global financial crisis of 2007 and 2008 led many banks to reassess the process for determining which businesses do and do not get loans. This created challenges for many small businesses that need loans to keep their businesses running, a situation that continued even after the recession ended in 2010.

SOURCES OF DEBT FINANCING

Small businesses can obtain debt financing from a number of different sources. Private sources of debt financing include friends and relatives, banks, credit unions, consumer finance companies, commercial finance companies, trade credit, insurance companies, factor companies, and leasing companies. Public sources of debt financing include a number of loan programs provided by the state and federal governments to support small businesses.

Private Sources. Many entrepreneurs begin their enterprises by borrowing money from friends and relatives. Such individuals are more likely to provide flexible terms of repayment than banks or other lenders and may be more willing to invest in an unproven business idea, based on their personal knowledge and relationship with the entrepreneur. A potential disadvantage is that friends and relatives may try to become involved in the management of the business. Business owners who wish to avoid such complications must use the same formal arrangements with relatives and friends as with more distant business associates.

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Banks are the most obvious sources of borrowed funds. Commercial banks usually have more experience in making business loans than do regular savings banks. Credit unions are another common source of business loans; these financial institutions are intended to aid the members of a group, such as employees of a company or members of a labor union. Credit unions often provide funds more readily and under more favorable terms than banks. However, the size of the loan available may be relatively small.

Finance companies generally charge higher interest rates than banks and credit unions. Most loans obtained through finance companies are secured by a specific asset as collateral, and the lender can seize the asset if the small business defaults on the loan. Consumer finance companies make small loans against personal assets and provide an option for individuals with poor credit ratings. Commercial finance companies provide small businesses with loans for inventory and equipment purchases and are a good resource for manufacturing enterprises. Insurance companies often make commercial loans as a way of reinvesting their income. They usually provide payment terms and interest rates comparable to a commercial bank but require a business to have more assets available as collateral.

Trade credit is another common form of debt financing. Whenever a supplier allows a small business to delay payment on the products or services it purchases, the small business has obtained trade credit from that supplier. Trade credit is readily available to most small businesses, if not immediately then certainly after a few orders. The payment terms may differ between suppliers, however. A small business's customers may also be interested in offering a form of trade credit—for example, by paying in advance for delivery of products they will need on a future date—in order to establish a good relationship with a new supplier.

Factor companies help small businesses to free up cash on a timely basis by purchasing their accounts receivable. Rather than waiting for customers to pay invoices, the small business can receive payment for sales immediately. Factor companies can either provide recourse financing, in which the small business is ultimately responsible if its customers do not pay, and nonrecourse financing, in which the factor company bears that risk. Although factor companies can be a useful source of funds for existing businesses, they are not an option for start-ups that do not have accounts receivable. Leasing companies can also help small businesses to free up cash by renting various types of equipment instead of making large capital expenditures to purchase it. Equipment leases usually involve only a small monthly payment, plus they may enable a small business to upgrade its equipment quickly and easily.

Entrepreneurs and owners of start-up businesses must almost always resort to personal debt in order to fund their enterprises. Some entrepreneurs choose to arrange their initial investment in the business as a loan, with a specific repayment period and interest rate. The entrepreneur then uses the proceeds of the business to repay himself or herself over time. Other small-business owners borrow the cash value of their personal life insurance policies to provide funds for their business. These funds are usually available at a relatively low interest rate. Still others borrow money against the equity in their personal residences to cover business expenses. Mortgage loans can be risky: the home is used as collateral. Finally, some fledgling business people use personal credit cards fund their businesses. Credit card companies charge high interest rates, which increases the risk of piling up additional debt, but they can make cash available quickly.

Public Sources. The state and federal governments sponsor a variety of programs that provide funding to promote the formation and growth of small businesses. Many of these programs are handled by the U.S. Small Business Administration (SBA) and involve debt financing. The SBA helps small businesses obtain funds from banks and other lenders by guaranteeing loans up to $2 million, to a maximum of 75 percent to 85 percent of the loan value, for 2.25 to 3.75 percentage points above the prime lending rate. (However, loans smaller than $25,000 may have slightly higher interest rates.) In order to qualify for an SBA-guaranteed loan, an entrepreneur must first be turned down for a loan through regular channels. The borrower then goes back to the lending institution to see if he or she can get the same loan if it were guaranteed by the SBA. The borrower must also demonstrate good character and a reasonable ability to run a successful business and repay a loan. SBAguaranteed loan funds can be used for business expansion or to purchase inventory, equipment, and real estate. In addition to guaranteeing loans provided by other lenders, the SBA also offers loans for disaster assistance.

Small Business Investment Companies (SBICs) are government-backed firms that make direct loans or equity investments in small businesses. SBICs tend to be less risk-averse than banks, so funds are more likely to be available for start-up companies and small businesses. SBICs define a small business as one that has a net worth of less than $18 million. Another advantage is that SBICs are often able to provide technical assistance to small-business borrowers. The U.S. Economic Development Administration (EDA), a branch of the U.S. Department of Commerce, makes loans to small businesses that provide jobs in economically disadvantaged areas. Small businesses hoping to qualify for EDA loans must meet a number of conditions pertaining to regional or local economics.

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BIBLIOGRAPHY

Davidson, Alex. “A Look at the Future of Small-Business Financing.”Wall Street Journal. 3 November 2014. Available from: http://www.wsj.com/articles/a-look-at-the-future-ofsmall-business-financing-1414965257 .

Leach, J. Chris, and Ronald W. Melicher. Entrepreneurial Finance. 5th ed. Stamford, CT: Cengage Learning, 2015.

Pakroo, Peri. The Small Business Start-Up Kit: A Step-by-Step Legal Guide. 9th ed. Berkeley, CA: Nolo, 2016.

Roberts, Richard G. Finance for Small and Entrepreneurial Businesses. New York: Routledge, Taylor & Francis Group, 2015.

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U.S. Economic Development Administration. “Funding Opportunities.” Accessed 20 July 2016. Available from: https://www.eda.gov/funding-opportunities/ .

U.S. Small Business Administration. “Financing Your Small Business.” Accessed 20 July 2016. Available from: https://www.sba.gov/sbic/financing-your-small-business .

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Gale Document Number: GALE|CX6062700171