What is debt finance?

In the UK, the perception of limited funding for startups often overlooks the diverse capital opportunities available. From traditional loans to innovative strategies like invoice finance, numerous funding sources exist.

But not all are suitable for every type of business. The choice may vary depending upon the industry or region your business is in. It will be influenced by how much money you need and what other security or finance you can offer when setting up.

There are two main types of capital; debt and equity. They are very different and will have a big difference on the business as it grows and develops.

What is debt finance? Quick Explainer

The Bank of England noted in its 1999 paper, ‘Finance for Small Firms’, that the vast majority of small firms are now financed through internal finance. However, of the 39% that do seek external funding, the majority are still funded by a bank loan. This is the most typical form of debt financing. The loan typically has to be repaid at an agreed interest rate and within a specified period of time. The interest rate can either be floating or fixed rate.

Typically the loan is secured against an asset. This means that if the business fails to repay the loan, the lender has the right to claim the asset. An asset could be a house or other premises or some equipment owned by the business. As the loan is secured, the cost is usually less than other more risky types of borrowing. However, a bank loan also locks companies into a payment schedule that may cause problems for small businesses.

You will have to be able to show how the money will be repaid and are likely to have to provide some kind of security for a loan or overdraft. If you are unwilling to put personal assets on the line, the bank is unlikely to lend you money.

The straitjacket of making a set payment at what may be a fixed interest rate can also cause a lot of problems for fast-growing companies that consume capital very fast.

For these reasons, loans are more suited to tried and tested business models that offer good prospects for profitability.

Debt Finance and Overdrafts

Debt finance can also take the form of an overdraft. This is generally linked to working cashflow rather than capital expenditure. It is repayable on demand and exceeding the limits can be expensive.

Following the last recession, the Bank of England has promoted alternatives to overdrafts. Many small businesses had been using overdrafts not just for working cashflow but also to finance long-term capital expenditure. When the economic downturn took full effect, many credit facilities were called but businesses were unable to repay them or left without vital cashflow.

Now banks are increasingly offering term loans to small businesses as an alternative to using an overdraft facility. In particular, it allows the banks to impose a regular repayment schedule over a fixed period of time and to see the amount of credit gradually reducing.

Other types of debt finance that are increasingly popular include leasing, a way of borrowing to buy specific equipment or machinery, or factoring and invoice discounting, where the small business borrows against sales.

In fact there is a vast range of different debt financing tools and each business should find the one that is right for its business, according to Claire Martin, senior manager small business services at NatWest.

If your business needs some working capital but the amount fluctuates, an overdraft is probably best for you. The interest rate is agreed in advance and you only pay interest for the time and amount that you are overdrawn. Businesses that need longer-term finance, in particular for a specific purchase or planned expenditure, should look to take a loan that can be repaid over a set period.

There are many reasons why debt finance could suit your business – it is accessible, flexible and tailored. Debt finance will be the first option for most small businesses. With debt finance, whether it is loans, overdrafts, leasing or invoice discounting, the company is borrowing against reserves rather than giving someone ownership of shares,” explained Martin.

However, there is one reason that most businesses will borrow money rather than sell shares in the business. “Debt finance is normally available from organisations in smaller amounts than equity,” explained Martin, and unless the company is very large it will be too small for formal equity.

Conclusion

Despite the common complaint that there is a lack of money available for startups in the UK, there are actually many sources of capital on offer.

But not all are suitable for every type of business. The choice may vary depending upon the industry or region your business is in. It will be influenced by how much money you need and what other security or finance you can offer when setting up.

There are many reasons why debt finance could suit your business – it is accessible, flexible and tailored.