Understanding Debt Finance

Debt finance is a common source of finance for startups and established businesses. Most debt finance takes the form of a loan that you repay to the lender, along with additional fees or interest. You’ll often have to provide personal guarantees, which can put your personal finances at risk.

In this guide, we look at the different types of debt finance and the potential risks you need to look out for.

What are the different types of debt finance?

Bank loans

Bank loans are one of the most common forms of debt finance. Often called ‘term loans’, they are repaid over a set period. Loans are usually secured against a business asset or one of your personal assets. This way, the lender has some security if you don’t make your loan repayments in full.

Lenders charge interest on the full amount of the loan, so it is important to borrow only the money you need.

When looking for a bank loan, it’s useful to shop around to see what deals are available from both online and high-street banks. Compare the different interest rates, loan terms and agreements offered by other banks. Think about whether the repayments will be manageable.

It is also worth checking whether any incentives are available, such as an initial repayment holiday, reduced initial interest rate or reduced set-up fees.

Commercial mortgages

Commercial mortgages are loans that are typically used to buy, refinance or develop business property. You typically repay them over long periods of 10-20 years or more. However, some commercial mortgages have repayment periods as short as three years. Mortgages are secured on your property, which will be at risk if you default on the repayments.

Most banks and building societies provide commercial mortgages, and all will investigate your business’s current position, outlook and credit history before considering your application. Some may also check your personal credit history.

Overdrafts

An overdraft is a simple, flexible way to finance your business. The lender will set a maximum level of overdraft that you should not exceed. You only pay interest on the amount that is overdrawn. The interest rate is usually higher than on a loan but interest is calculated daily, so it is often a cheaper option.

Overdrafts typically finance short-term cash flow requirements rather than capital items. They are repayable on demand and the lender will usually require security. As with bank loans, you usually have to pay set-up fees when you take out an overdraft.

It's important to work out how much your business actually needs to borrow. Be realistic: if your business doesn’t borrow enough, it might be tricky to go back to lenders for more.

Credit cards

A business credit card is a convenient form of finance that lets you make purchases up to an agreed credit limit and pay for them at a later date.

You are sent a bill each month covering all the purchases you have made. You don’t have to repay the whole amount owed, but interest is charged on the outstanding balance. Interest rates are usually higher for credit cards than overdrafts and loans, so it can be an expensive way of financing your business purchases.

You may be able to take out a 0% interest credit card, which will offer an initial interest-free period.

Factoring and invoice discounting

Factoring and invoice discounting allows your business to “sell” some or part of your invoices to a factoring company. This way you can receive any money owed to you by your customers without having to wait for them to pay.

Factors advance a certain percentage of the value of approved invoices (usually 70% to 85%). Your business will raise the invoices and send them to customers as usual. The factor will collect the payments. Your customers pay the factor directly, and you receive the balancing payment, minus the factor’s fee and interest.

Invoice discounting is similar to factoring except that responsibility for collecting payments from customers remains with your business. Invoice discounters charge a monthly fee plus interest on the net amount of cash advanced. Because customers pay the business directly, they are unaware that this facility is in place.

Asset finance

Asset finance is where the lender provides you with finance so that you can buy capital equipment (such as machinery or tools) for your business, and the loan is secured on the asset that you buy. There are two types of asset financing: leasing and hire purchase. With leasing, the asset is returned to the lender at the end of the lease period. With hire purchase, you take ownership of the asset at the end of the agreement, once the full amount has been repaid.

Understanding Debt Finance

Choosing the most appropriate debt finance

The most appropriate type of debt finance for your business will depend on a number of factors:

  • How much you need to borrow.
  • How you will use the money.
  • The period of the loan.
  • The security required.
  • The repayments you can afford.
  • The level of risk you are comfortable taking.

For example, you could resolve a short-term cash flow problem with an overdraft. However, if you need to buy expensive equipment, a longer-term bank loan or asset finance may be more appropriate.

Deciding how much to borrow

To help you decide how much to borrow, it’s important to consider what the money is needed for and to estimate the total cost of borrowing the money.

It’s a good idea to prepare a detailed cash flow forecast and include the repayments, interest and any fees associated with the debt. This will help you decide if you can manage the repayments.

Providing information for lenders

You’ll need to provide information to help lenders decide whether to approve your application. This typically includes:

  • Business bank statements.
  • Accounts for the last two years.
  • Budgets and cash flow forecasts.
  • Details about customers.
  • Details about business assets for security.

Risks of debt finance

The ultimate risk of debt finance is being unable to make the necessary repayments, for whatever reason. The lender could seize and sell any business assets that you provide as security, in order to pay off the remaining debt. If the debt was secured under a personal guarantee, the individual or individuals who gave the guarantee would have to pay the debt.

If you get into any financial difficulties, it’s important to tell the lender as soon as possible so that any issues can be resolved. Putting things off or trying to deceive lenders will only create bigger problems in the long run.

Hints and tips

  • Plan ahead. It can take time to secure the right form of debt finance. Prepare detailed forecasts that can be provided to potential lenders.
  • Consider the types of debt finance available to your business and discuss them with an accountant or other business adviser.
  • Work out how much your business actually needs to borrow. Be realistic: if your business doesn’t borrow enough, it might be tricky to go back to lenders for more.

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DISCLAIMER While all reasonable efforts have been made, the publisher makes no warranties that this information is accurate and up-to-date and will not be responsible for any errors or omissions in the information nor any consequences of any errors or omissions. Professional advice should be sought where appropriate.

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