Four debt financing rules to factor in

Debt financing involves borrowing funds from a lender. The lender is usually a bank but can also be a private lender, a superannuation fund, or family member.

The loan terms vary from loan to loan and include the interest rates (fixed, variable or a combination), principal repayment terms (monthly, yearly, or only at the end of the loan), and security (real estate, business assets or personal guarantees only).

If debt financing is used wisely it enables a business to invest and expand faster than it would be able to if just using its own financial resources. If used inappropriately it often ends in the business closing and the owner in financial trouble.

Four debt financing rules:

  • Debt financing is not suitable for start-up businesses. Start-up businesses must be financed by equity as they have little revenue and operate at losses so cannot support the burden of interest and loan payments.
  • Debt financing is only suitable for profitable businesses with reliable cash-flows. Businesses with fluctuating cash flows must be financed by equity, as debt interest and principal payments are fixed and must be met monthly irrespective of business cash flow.
  • Short term debt should not be used to make long term investments. Doing this creates problems as the short term debt will need to be refinanced well before the long term investment returns are available. If the short term debt cannot be refinanced, the lender will either sell or close the business.
  • Increasing debt increases business risk. Borrowers need to ensure their cash flows have a margin of safety to allow for rising interest rates, slower revenue than expected or unexpected costs.

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