Capital and funding are the basic requirements to run a business. There can be long term or short term need. Such needs can be fulfilled in two ways i.e. by equity or debt. Business structures other than a company cannot raise funds through equity except One Person Company. Hence debt financing is the only option for startups to raise funds.
Debt financing for startups means getting the borrowed funds. When a startup borrows money from outside at interest, it is called finance through debts. It can be a loan from banks or financial institutions or deposits or debentures, etc. This is an easy way of raising funds.
Sources of Debt Financing for Startups & SMEs
Loans & Advances
Getting Loans & advances are a common source of debt financing for startups and SMEs. Loans are for the long term needs of the business. One can avail loan from a Bank and Financial institution with or without security as per the terms and conditions. These days, banks and financial institutions have introduced many schemes & plans to ease the funding for startups. Advances are for short term requirements. It can be in the form of overdraft or credit facility from the banks. It is useful for the needs of working capital.
A company can take a loan from another company for financial requirements. While taking such loan it has to comply with the provisions of the Companies Act.
Only a private limited company registration
Trade credit involves the purchase of the goods or raw materials at credit and payable later. It is a very common and preferable mode for startups. It fulfills the need for day to day capital requirement. Also, it is less expensive than a loan from a bank. There is no need to provide any security for such kind of credits. The entities with high goodwill will easily get a credit in the market.
It means buying goods at instalments by entering into a hire-purchase agreement. But it is different from simply buying goods at instalments. Only capital goods are purchased through hire purchase. Here, the ownership of goods transfers only when the seller receives the full payment. But the buyer has the right to use it. If the buyer is unable to pay the amount then the seller can repossess the goods.
A person will buy all the receivables of the company and will pay the amount against it at a commission. Such a person will be known as a factor. Hence, an entity can get the amount of receivables in advance before the due date. At the time of the due date, the factor will collect the receivables. If there are any bad debts then the entity will not be liable for the same. It is used for short term requirements.
Points to be considered while debt financing
Cost of Debt Financing
- In debt financing, the interest or the commission paid against the loan is considered as the cost of debt. One must calculate the cost before taking debts.
- One must compare the rate of return on the capital. If the rate of return is less than the cost of debt then such a project will not be profitable.
- One must also check the debt-equity ratio. It is good to have a low debt-equity ratio.
- One must calculate the risk involved in debts.
Debt financing is a great source of financing. It serves long term as well as short term needs. The advantage of debt financing is that there is no need to share the ownership with anyone. Hence, the control remains with the promoters without any interference from outsiders.