In the broadest sense, debt finance is used to describe a business borrowing money which it commits to return with interest in the future.
This could be in the shape of either a secured or an unsecured loan which your company could use to fund an acquisition or to raise working capital.
Types of debt finance
There are many types of debt finance which include selling bonds, bills or notes to investors (individuals or organisations). Based on the type of financing you need, debt finance can be split into two categories – short-term and long-term.
If you need to finance the daily operations of your business, such as paying your employees, purchasing supplies or paying rent, consider short-term debt finance. Often referred to as an operating loan, this type of debt finance requires a repayment within the year.
Long-term debt finance, on the other hand, is suitable if you are looking to purchase assets for your business. This could be technology, buildings or even land. The expected repayment of this loan stretches over longer time period, and is secured by the assets you are using it to purchase.
In fact, most debt finance is often secured against capital assets or personal guarantees.
Advantages and disadvantages of debt finance
The main advantage of debt finance over alternative sources such as equity is that it allows you to maintain full control over business operations. You might also be able to extend the repayment of your long-term loan for as long as you need, and claim your interest costs as business expenses when doing tax.
The biggest disadvantage of relying on debt financing is that banks require a collateral for the loan, which is often the assets of your social business. Or, if you own a start-up whose assets are insufficient for collateral, you may need to provide a personal guarantee. Repaying a loan will also make it more difficult to expand your business.
Explore the different types of debt finance available for your social business:
Overdrafts
An overdraft is a sum of money extended to you as credit by your bank, set at a pre-arranged limit when your account balance drops below zero. Banks usually charge interest on any amount of overdraft you use, but the terms and price of overdrafts will vary between providers.
Security and personal liability
Most lenders require some form of security on the money that they are lending - if the borrower can no longer repay the loan, then the lender wants to maximise the likelihood of getting their money back.
Loan stock and bonds
Loan stock is stock issued to an organisation in return for a loan. It earns interest and is a form of debt, but it has many of the features of a risk investment.
Debentures
A debenture is a corporate bond (a written, signed, unconditional, and unsecured promise by one party to another that commits the maker to pay a specified sum on demand, or on a fixed or a determinable date) which is backed generally by the borrower's specific assets.
Factoring and invoice discounting
Factoring – also known as 'debt factoring' – involves selling your invoices to a factoring company. In return they will process the invoices and allow you to draw funds against the money owed to your business.
Debit and credit cards
Credit cards are generally used in cash transactions (i.e. purchases that need paying at the annual service charge).
Non-bank lenders
A loan is an amount of money borrowed for a set period within an agreed repayment schedule. The repayment amount will depend upon the size and duration of the loan and the rate of interest.
Bank loans
A loan is an amount of money borrowed for a set period within an agreed repayment schedule. The repayment amount will depend upon the size and duration of the loan and the rate of interest.