The Wealth Spa

Dangers of Financing with Debt

Posted on 20. Mar, 2008 by Elizabeth Potts Weinstein in Finance

Debt financing, one of the 3 primary methods of financing a business (the other two are self-financing and equity financing), is obtaining money that must be paid back to the lender, usually with interest.  Similar to self-financing, debt financing may include both using your personal credit as well as the credit and security of the business to obtain a loan or line of credit. 

Personal debt financing is readily available to most business owners.  If you have a decent credit rating, you can obtain credit cards, a home equity line of credit, or a loan, without informing the bank about your business.  You may obtain a loan from a family member or friend who knows about your business venture but who may not demand as rigorous standards as a formal bank. 

To use a business’s credit as security for a loan, it must be a separate legal entity from the business owner.  If you are operating as a sole proprietorship, you are personally liable for the loan, even if you sign the application in the name of the business.

Businesses may also obtain credit cards, lines of credit, and loans from banks and credit unions.  Loans that are secured by the Small Business Administration (SBA) are available through banks providing lines of credit to small businesses that may not be able to obtain credit without the SBA guarantee.  Alternative debt financing options such as Prosper.com enable individuals and businesses with lower credit ratings to obtain financing from diverse sources.  But these private loans will typically be at interest rates higher than SBA loans. 

What are the benefits of debt financing?

• You may already have personal debt available, without any application or new disclosures to your lender.
• Loans are readily available, guaranteed by the SBA, for modest loan amounts (four to five figures).
• You usually need to create a business plan for a business loan, which requires you to think through and evaluate your business venture.
• Leverage.  You can use a small amount of your own money, partner it with a loan, and create a moderately large business venture.  The potential return on your investment is higher, because you have invested less of your own money.
• Interest, as of the date of the writing of this book, is relatively low compared to historical rates. 
• You can obtain a line of credit or credit card to only be used if you have short-term cash flow problems.  Perhaps you will not even need to use it. 

What are the dangers of debt financing?

• You may have to personally sign for the loan.  If your business is organized as a sole proprietor, or if your business plan or credit is not sufficient, the lender will require you to personally secure the loan.  If the business goes under, you are liable to pay for the loan.
• Your monthly overhead increases to pay the monthly payments on the loan interest and principal.
• You may view debt as "free money" instead of evaluating the costs and benefits of all your expenses. 
• You are in debt.  This debt must be subtracted before you can take home profits when you sell your business. 

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Tags: Finance & Debt