Debt Financing and its Purposes
Traditional Finance theory says that Debt Financing is the best source of capital for your business that doesn’t dilute your ownership. So, why don’t business owners simply borrow all that is available to them?
Unlike equity, debt financing has to be repaid, with interest, and requires consistent cash flows to be generated from your business. So, you need to be very deliberate when utilizing debt.
The purposes of debt are essentially the same as those for Equity:
1. Growth & Expansion of the business
2. To bridge a period of Adversity or Losses – to a future period of cash flow, or
3. To Return Liquidity back to owners, through a company sale, or “cashing out” some of the value that has accumulated.
Debt financing is also a function of Risk and Return from the perspective of the Lender. What that means is their rates and terms that are available to you are based on the lender’s perceived risk in your ability to repay. The more confidence they have, the more favorable your terms will be and vice versa. This Risk and Return concept is very important and is one of the primary things driving the different structures and sources of debt financing in the market.
Most business owners have grown their business through a number of discreet financing decisions along the way. And they might have been the best at the time, but it’s definitely worthwhile to look at your debt from a more holistic perspective, to find out if there is another or better product for the next phase of your business. It can also help you understand if perhaps you need to consider Equity as an investment at that time as well.