Debt Financing

Related Terms: Capital Structure; Equity Financing

A business can finance its operations either through equity or debt. Equity is cash paid into the business by investors; the business owner is usually one of these investors; investors receive a share of the company, in effect a percentage of it proportional to total investment paid in. The share or stock may appreciate in value in proportion to the increase in the business's net worth—or it may evaporate to nothing at all if the business fails. Investors put cash into a company in the hope of stock appreciation and the yield of dividends which the business may (but need not) pay to the investor; dividends are a portion of the net profits of the business; if the business does not realize a profit, it cannot pay a dividend. The investor can get his or her investment back only by selling the share to someone else. In a privately held company, investors have less "liquidity" because the shares are not traded on the open market and a purchaser may be difficult to find. This is one reason why successful and rapidly growing small businesses are under pressure by stockholders to "go public"—and thus to create an easy way for investors to cash out.

Debt financing, by contrast, is cash borrowed from a lender at a fixed rate of interest and with a predetermined maturity date. The principal must be paid back in full by the maturity date, but periodic repayments of principal may be part of the loan arrangement. Debt may take the form of a loan or the sale of bonds; the form itself does not change the principle of the transaction: the lender retains a right to the money lent and may demand it back under conditions specified in the borrowing arrangement.

Lending to a company is thus at least in theory more safe, but the amount the lender can realize in return is fixed to the principal and to the interest charged. Investment is more risky, but if the company is very successful, the upward potential for the investor may be very attractive; the downside is total loss of the investment.

DEBT/EQUITY RATIO

The character of a company's financing is expressed by its debt to equity ratio. Lenders like to see a low debt/equity ratio; it means that much more of the company's fortunes are based on investments, which in turn means that investors have a high level of confidence in the company. If the debt/equity ratio is high, it means that the business has borrowed a lot of money on a small base of investments. It is then said that the business is highly lever-aged—which in turn means that lenders are more exposed to potential problems than investors. These relationships ultimately highlight a certain ambiguity in the relations between lenders and investors: their aims are in conflict but also in mutual support. Investors like to use a small investment and leverage it into a lot of activity by borrowing; lenders like to lend a small amount secured by a large investment. In usual business practice these motivations result in a negotiated equilibrium which shifts this way and that based on market forces and performance.

The U.S. Small Business Administration, on its Web page titled "Financing Basics," draws the following conclusion for the small business: "The more money owners have invested in their business, the easier it is to attract [debt] financing. If your firm has a high ratio of equity to debt, you should probably seek debt financing. However, if your company has a high proportion of debt to equity, experts advise that you should increase your ownership capital (equity investment) for additional funds. That way you won't be over-leveraged to the point of jeopardizing your company's survival."

CASH FLOW TO DEBT RATIO

The cash flow of a company in relation to its debt serves lenders as another way to measure whether or not to provide debt financing to a business. A company's profitability, as measured on its books, may be better or worse than its cash generation. In calculating cash flow, only actual cash coming in and going out in a given period is used to calculate net cash available for servicing debt.

The sales of a company for a given period, for example, may be considerably higher than its cash receipts; the reason for this may simply be that the company's customers may paying late or may have favorable "stretched out" payment arrangements. Similarly, the costs of a company, as recorded on its books, may be lower than its actual cash payments in a period; the company, for instance, may be prepaying insurance for the next six months this month; it's books will only show one sixth of that payment as cost but six times as much going out as cash. For these reasons, a company may be profitable based on its books but may be short on cash at any given time. Lenders therefore like to look at the amount of cash available to service the current portions of any new debt. If this amount is minimally 1.25 times the debt service required, the business is at least in the ballpark to receive a loan. The higher this ratio, the more inclined the lender will be to lend.

Rules of thumb along these lines are subject to adjustment based on the availability of money. As Daniel Rome Levine pointed out early in 2006, commenting on the money market in Chicago, writing for Crain's Chicago Business, "[S]ince the 2001 recession, many entrepreneurs have learned to do more with fewer resources and pared down their debt." Interest rates were low and banks were loosening their terms. "These days," Levine wrote, "[banks] are going as low as 1.1 times debt for companies with strong balance sheets." A tightening of money and less favorable small business profiles will once more push the ratio up.

SOURCES OF DEBT FINANCING

Small businesses can obtain debt financing from a number of different sources. Private sources of debt financing include friends and relatives, banks, credit unions, consumer finance companies, commercial finance companies, trade credit, insurance companies, factor companies, and leasing companies. Public sources of debt financing include a number of loan programs provided by the state and federal governments to support small businesses.

Private Sources

Many entrepreneurs begin their enterprises by borrowing money from friends and relatives. Such individuals are more likely to provide flexible terms of repayment than banks or other lenders and may be more willing to invest in an unproven business idea, based upon their personal knowledge and relationship with the entrepreneur. A potential disadvantage is that friends and relatives may try to become involved in the management of the business. Business owners who wish to avoid such complications must use the same formal arrangements with relatives and friends as with more distant business associates.

Banks are the most obvious sources of borrowed funds. Commercial banks usually have more experience in making business loans than do regular savings banks. Credit unions are another common source of business loans; these financial institutions are intended to aid the members of a group—such as employees of a company or members of a labor union—they often provide funds more readily and under more favorable terms than banks. However, the size of the loan available may be relatively small.

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