Debt Financing

What It Means

Unlike equity financing, in which owners offer part of their business ownership in exchange for funds, debt financing is simply borrowing money from non-owner creditors, who must be repaid over a period of time. One key advantage of debt capital is that the interest paid is tax-deductible, which can make debt financing cheaper than equity.

The ratio of debt to equity capital establishes the firm’s financial leverage. Note that a highly leveraged capital structure may be good, since the firm uses other people’s money to fund its growth.

However, the company must generate sufficient earnings to meet its debt obligations. This is often measured by the debt service coverage ratio which relates the firm’s total available cash flow to the amount of debt service.

Typical forms of debt financing for small business purchases are:

• Seller’s notes.
• SBA 7(a) or commercial loans.
• Vendor financing.