Disadvantages of debt financing

The disadvantages of debt financing outweigh any potential benefit you may get from it, but I know what works for someone may not work for another, so it is up to you to know the examples of debt financing available with their disadvantages and make the decision yourself whether it is good for your company or not. For instance, it’s definitely a lot less risky for someone who has plenty of collateral to pledge in case things go downhill but you do need to carefully weigh out the pros and cons of debt financing before opting to use it as a source of finance! Below, I outline major debt financing disadvantages and explain what it means to your business.

The greatest disadvantage of debt financing is that your business could be taken away from you

If things don’t go according to plan and your business doesn’t make enough money to even meet interest payments, it’s almost certain that you won’t be able to repay the principal and this could prove disastrous – especially when large sums of money are involved e.g., bankruptcy. In this case, other secured creditors such as banks or finance companies could take over your business in the event that you’re unable to repay them back or you may end up with a court-appointed trustee who will sell off all assets and distribute profits from those sales to creditors until there is no longer any money left.

This is quite different from equity financing where, unless there are specific clauses in place, investors have no claim on any of your company’s assets in case they aren’t being repaid.

Another major disadvantage of debt financing is that it can be expensive

A major disadvantage of debt financing is that it can be expensive e.g., interest charges and this means that it may not be feasible when you need smaller sums of money for short periods of time. For example, credit card debt is only an option if you have enough disposable income to pay it back so quickly or within a reasonable timeframe. Otherwise, you’ll find yourself paying extremely high-interest rates plus various fees, especially when your business’ Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is low; it means any loans that you take out will require large monthly interest payments–and this could prevent you from making the capital investments that are necessary to expand your company. This could put a great dent in your finances!

It can create cashflow problems

If your company’s sales fall below expectation or production costs rise, you may find that you don’t have sufficient cash flow coming in to pay off all your creditors. You can end up having to divert funds from other areas just to be able to cover operating expenses – and this creates more problems long term.

Another debt financing disadvantage resulting from a cash flow crisis is that it can plunge the business into higher levels of debt which could be problematic if things go south. At the very least, you’ll have to rely on credit lines or loans just so that your business can continue operating; these loans often come with high-interest rates.

You may bear a higher risk

You will generally have to bear higher risk since banks generally require borrowers to pledge collateral, especially when high amounts are involved e.g., real estate. If things don’t work out as planned, you may lose these assets if they weren’t adequately protected against the risks involved such as bankruptcy or seizure in some jurisdictions. This is not true for equity financing – where even in cases of extremely low success rates, investors only stand to lose what they contributed and nothing more!

Too much paperwork and legal documentation

One of the disadvantages of debt financing is that it generally involves a lot of legal paperwork and documentation  – which means that you will have higher administrative costs to deal with, especially if it’s a large amount of money you’re borrowing.

It requires high levels of transparency

Debt financing requires high levels of transparency from the borrower since banks and other financiers demand detailed financial statements so they can assess your ability to repay back in full and on time.

Interest charges may accumulate

Interest charges add up over time and reduce the overall returns for investors. This is why venture capitalists tend not to allocate much funds towards debt-financed companies! However, this does not mean that there’s no place for debt financing in start-ups – just that equity financing carries more advantages in most cases.

You may use your personal money

You will have to dig deeper into your pockets to repay the loan in case you take on additional debt financing. The more money that you are borrowing, the higher are your chances of incurring much larger interest charges – which could be an issue if your business doesn’t generate adequate revenue to pay them off easily.

It limits future borrowing options

You may find that when you apply for additional financing (such as venture capital or an SBA Loan), lenders will be reluctant to work with you because they’ll see your high debt-to-asset ratio and realize that your junk bond credit rating means you’re a high risk for default.

The above are some disadvantages of using debt to finance a business but not all businesses are exposed to the same problems, hence the disadvantages may vary according to the situation of each business.

FAQs on disadvantages of debt financing