Finance writer John Cradden looks at the various forms that debt finance can take and what options are available to SME business owners.
If an SME needs to raise money, whether it’s to pay bills, maintain its operations or invest in future growth or development, it generally has two financing options: sell shares or take on debt.
There are many reasons why you might choose debt financing over equity financing, but the main one is that it doesn’t require giving up any control or ownership of your business. The downside, of course, is that, unlike equity financing, you will have to pay back the money.
“The key to managing debt finance is to pick the right option for your business. Think about the needs and financial goals. Find out how much you are able to pay back each month and decide which assets you are willing to risk to secure the loan, should that be necessary”
That said, many SMEs will use a combination of both to give themselves more flexibility when it comes to raising much-needed cash, although ideally making sure there is a good balance between the two types of finance.
There also exist ‘hybrid’ products that combine elements of debt and equity financing, such as ‘venture debt’ or ‘quasi-equity’, but these can be quite complex. This article will focus on debt finance options involving straightforward borrowing from a lender that is paid off over time.
Types of debt finance
Debt finance usually comes in the form of loans, but there are many other types as well, including credit lines, overdrafts, leasing, asset-backed financing and peer-to-peer lending, to name a few.
It can be useful to categorise the different types according to whether they are used for short term or long-term purposes.
Debt finance that is taken out for short-term purposes will often be used as working capital, and the choices here include overdrafts, business credit cards and invoice financing (loans secured against your outstanding invoices).
Overdrafts enable your business to issue payments or make withdrawals on a business current account up to a certain limit. Interest is usually charged on a daily basis on the amount of the overdraft used, along with quarterly fees and annual facility fee.
Business credit cards are also intended as very short term, allowing you to put expenses on a card and avoid having to tap your company’s cashflow for around 35 days to pay for goods or services.
Invoice finance is a working capital facility that releases cash currently tied up in outstanding customer invoices, and is designed to help your business improve cashflow and therefore more flexibility to grow.
There is an element of invoice financing in asset-backed lending, a type of debt finance that leverages valuable assets a business might own as security for a loan. This can be used as working capital or even to help fund business expansion.
For longer-term purposes, such as for capital expenditure, common types of debt finance include term loans and leasing or hire purchase, but also asset-backed finance (not to be confused with asset finance). Term loans are exactly what they say on the tin: loans that are repaid over a specified term, usually between one and 10 years. These are often for larger purchases such as investment in capital equipment or business premises via a commercial mortgage.
Leasing finance is often used to fund moveable equipment, from machinery to transport vehicles. Under a leasing agreement, the lender buys the asset and leases it back to the business for a period of a few years in return for a monthly payment, at the end of which the business can extend the lease, trade the asset in or buy it outright.
Sources of debt finance
The vast majority of debt financing for SMEs comes from banks, but there’s also a growing range of non-bank or alternative lenders now operating in this space.
This includes companies that operate peer-to-peer lending platforms, through which you can borrow from other individuals or businesses, often with lower rates and without the need to put up any security. This allows for businesses to get help from people who are willing to take on some risk while still offering competitive terms relative to other types of loans.
There are also several Government and EU schemes and supports aimed specifically at providing debt finance to SMEs, such as those offered by Microfinance Ireland, the Strategic Banking Corporation of Ireland (SBCI) and the European Investment Bank (EIB).
Some of the supports and schemes available have been geared to help businesses struggling with external challenges such as the Covid-19 pandemic and Brexit.
These are generally available through most big banks and selected alternative lenders, so they will be able to tell you if your company might fulfil the relevant criteria to apply.
How to manage your debt finance
The key to managing debt finance is to pick the right option for your business. Think about the needs and financial goals. Find out how much you are able to pay back each month and decide which assets you are willing to risk to secure the loan, should that be necessary.
You should also take into account the level of interest rates available on different types of loans, which loan term will work best for you, and whether there are any additional hidden fees or charges.
Avoid taking too much debt in the first place. Risk is an inherent part of running any business but be realistic about what you can afford to pay back each month and avoid taking out loans based on how much you expect the business to be earning in the future.
For any type of debt finance, especially for longer-term purposes, it’s important not just to be able to demonstrate repayment capacity, but also to have a detailed business plan to present to the lender. Involve your accountant early on so that you have all the financial information required.
Always try to pay off the debt as quickly as possible, as many types of debt finance have very high interest rates. Some products will also allow greater flexibility regarding the length of time you can pay it off.
The money you use to repay the loan will usually come out of your profits, but if your business struggles to repay the loan then you will need to take action otherwise you could put your company at risk.