Sources of debt financing

The sources of debt financing refer to the ways through which businesses or companies get loans to fund their operations or acquire equipment. Businesses do this by borrowing from organizations or individuals and would pay back the borrowed capital with interest over a given period of time. This act of borrowing by businesses from lenders is called debt financing, and these organizations or individuals that lend to businesses are the sources of debt financing. There are many ways through which a business can get loans, each type of debt financing has advantages and disadvantages. The method you choose is based on the situation of your business; there are some debt financing options that are best for small businesses or startups while others are good for large corporations or companies.

We will consider the common debt financing sources with their advantages and disadvantages.

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Sources of debt financing

  1. Financial institutions
  2. Suppliers
  3. Retailers
  4. Family and friends
  5. Factoring companies
  6. Finance companies
  7. Business development companies (BDCs)
  8. Private equity firms
  9. Individual investors
  10. Asset managers

Financial institutions as a source of debt finance

These include banks, credit unions, and building societies; they offer a wide range of credit, both short-term and long-term loans. This source of debt financing is good for corporations or big companies with good credit history, assets, and established sources of revenue. The disadvantage of this type of debt financing source is that small businesses or startups find it difficult to get loans from them.

Types of debt offered by financial institutions

  1. Business loans
  2. Asset financing
  3. Lines of credit
  4. Overdraft services
  5. Equipment loans
  6. Equipment leasing
  7. Invoice financing

Of all the types of debt provided by financial institutions, business loans are the commonest because the businesses are provided with money that can be used for many purposes compared to equipment leasing which provides equipment only.

Suppliers

This source of debt financing involves a supplier of a product giving trade credit to a company (buyer) of good reputation. The buyer can collect a certain amount of products without paying for the goods or products immediately. This is done based on an established relationship of the supplier with the business buying the products. The disadvantage of this type of debt financing source is that the reputation and trust are not built overnight, it takes time and cannot be used for the immediate needs of a startup. Another con of using this is the limitation of providing a business or company with a single product or item instead of money that can be used for different purposes. In essence, there is no liquidity in this source of debt financing compared with loans that offer money. The advantage of this is that any form of business can benefit from it, both small and large businesses.

Retailers offering store credit as a source of debt financing

Some retailers can offer store credit to companies or businesses; these items may be furniture, gadgets, or office equipment. The retailers do this by liaising with finance companies that offer credit for buying items or equipment that the store is selling. The borrowing company does not buy directly from the store but can use a finance company that pays the store for any item bought; it is now left for the borrowing company to repay the finance company the debt incurred with associated interest. The disadvantage of this is that the goods may be costly above the normal market value and the interest rates are often high as well. There may be an interest-free period, during which the borrowing company can pay off the debt without any interest, therefore, this source of debt finance is best for businesses that can pay the debt quickly during the interest-free period.

Family and friends

Family and friends can be a very good source of debt finance especially for startups and small businesses; This debt finance source is not suitable for large companies. The advantage of this is that it has flexible terms such as no paperwork, no legal documentation, it is easy to talk with friends to get funds, and it offers lower interest. The major disadvantage is that the amount of money needed may not be enough; also relationships may be strained when you are unable to pay back as agreed.

Factoring companies

A factoring company is a type of business that specializes in securing customer invoices by purchasing accounts receivable. Most commonly, this purchase takes place when the client’s customers are slow to pay their outstanding bills. Rather than waiting for the client’s customers to eventually settle up, a factoring company expedites the process and pays out cash – along with an interest fee – in return for receiving the right to collect payment from its client’s customers at a later date. This is suitable for a business that has many debtors having outstanding bills that are yet to pay, what the business would do to get finance would be to sell the outstanding invoices to a factoring company that pays immediate cash for the outstanding balances (but at discount) and then acquire the right to collect payment from the customers. The disadvantage of these sources of debt financing is that your profit would be reduced because of the discount to the factoring company and you may lose customers because some factoring companies may harass them.

Finance companies

These are the companies that offer finance credit through retailers. Businesses can buy items such as furniture, computers, office equipment, etc through retailers that partner with these finance companies, and then pay the finance companies at a later time with/without interest depending on the agreement and terms. An example of a finance company is Affirm, which offers installment loans at the point of sale to finance a purchase.

Asset managers

Asset managers are financial intermediaries who make investments on behalf of clients such as pension funds, insurance companies, or mutual funds. They can be considered a kind of private investor with the difference that they do not only focus on equities but also on fixed income assets. In other words, they manage money for investors to earn a return from interest payments and capital gains.

Other common sources of debt financing

  1. Business development companies (BDCs)
  2. Private equity firms
  3. Individual investors

FAQs on sources of debt financing

What is the best source of debt financing?

The best source of debt financing for entrepreneurs, startups, or small businesses is through family and friends because it offers flexible terms and interest rates are low or zero, but it may not be enough to fund a business.
For established businesses with a good credit history and stable cash flow, bank loans are the best sources of debt financing because they offer larger amounts at low-interest rates over a longer repayment time.

What are the 4 sources of long term debt financing?

The 4 common sources of long-term debt financing are secured loans, unsecured loans, capital markets (or asset-backed borrowing), and asset sales (or securitization).

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