Debt financing is a term that describes any type of borrowing money where the borrower makes payments to the lender with interest, whether automatically applied or as a term for late payments. It gets its name because the borrower has a “debt” to the lender.
It’s the preferred method of financing for most businesses as the business owner or owners maintain control over the company compared to equity financing where the lender will gain partial ownership. And there is a debt financing solution for virtually any business situation.
The most common types of debt financing for a company are:
- Small business loans
- Commercial business loans
- Business lines of credit
- Business credit cards
- Invoice factoring
- Merchant cash advances
- Trade credit
- Mezzanine financing
The interest rates with debt financing can be variable or fixed, meaning they can change based on market conditions, or they remain the same throughout the length of the debt. Some options like a business loan or invoice factoring will have a set payback term with interest payments on each installment. Others will only have an interest payment when there’s an overdue balance like lines of credit and business credit cards.
Others like merchant cash advances use factor rates instead of percentages, and mezzanine financing is a hybrid between debt and equity financing. In addition to multiple ways that interest fees are collected, debt financing has sub-categories as well including revenue-based financing where the lender loans money for a percentage of future profits and includes merchant cash advances and invoice factoring. Sounds confusing right? Don’t stress, we’ve got you covered.
Below you’ll find a table with how the types of debt financing compare, then more information on each so you will be able to make the right choice for your business based on your situation. It is also normal for a company to have multiple types of debt financing as they may want a business credit card for small purchases and taking vendors out for a meal, and a small business loan to fund large operational enhancements like a new point of sale system.
How The Options Compare
Here’s how the different types of debt financing compare to each other so you can get an idea of what might be best for your situation before we share more details about each. Every lender and credit provider will be different – the goal of the table and additional information is to give you an idea of what to expect, so you’re informed when you apply.
|
|
Variable or fixed interest |
Small or large purchases |
Revolving or Installment (Fixed Term) |
|
Small business loans |
Fixed or variable determined by your agreement |
Small to mid-sized |
Installment |
| Commercial business loans | Fixed or variable determined by your agreement |
Large |
Installment |
| Business lines of credit |
Variable |
Small |
Revolving |
|
Business credit cards |
Variable |
Small to mid-sized |
Revolving |
|
Invoice factoring |
Fixed |
Small |
Installment |
|
Merchant cash advances |
Fixed (factor rates) |
Small |
Installment |
|
Trade credit |
Fixed |
Small to large |
Installment |
|
Mezzanine financing |
Fixed |
Large |
Installment |
Small business loans
Payment cycles: Terms normally in monthly increments
Amount: $5,000 to $1,000,000 with SBA 7(a) up to $5,000,000
Small business loans are the most flexible type of financing for a small to medium sized business that needs to spread the payments over a period of time between 3 months to 7 years.
There are customized options for just about any purpose including equipment financing, disaster recovery, hiring staff and upgrading computer systems, even marketing your business and renovating your reception area. Most are privately funded through banks and alternative lenders, and some are backed by the SBA which makes getting approved easier.
Commercial business loans
Payment cycles: Terms normally in monthly increments
Amount: $1,000,000+
Commercial business loans are for large amounts of money and can be used for virtually any purpose like a small business loan. While a small business loan could be used to open two new locations, commercial business loans are for launching a network of them or expanding overseas.
Anything that requires substantial capital will benefit from a commercial business loan like building a new office complex, buying a fleet of trucks and leasing a warehouse for a distribution center, and funding large scale mergers and acquisitions.
Business lines of credit
Payment cycles: Monthly payments
Amount: $10,000 – $250,000
Business lines of credit are pre-approved forms of revolving credit, meaning they refill once you pay the money back. They’re perfect for short-term and immediate purchases that are too large for a credit card and where you don’t have time to wait for a business loan. They can be used for virtually any purpose as long as it isn’t prohibited in your agreement with the financial institution.
Business credit cards
Payment cycles: Monthly payments
Amount: $5,000 – $100,000
Business credit cards are perfect for small purchases where you’ll pay the amount back quickly and you want to avoid interest payments like with a loan. This includes office supplies, automating monthly bills including rent and utilities, or taking your team to dinner. The funds are available immediately once you have the credit card number, and it is revolving like a line of credit, so it refills as you make payments.
While some business credit cards have unlimited spending caps, these are normally reserved for companies with high business credit scores, a substantial amount of cash reserves, and a proven track record of fiscal responsibility.
Invoice factoring
Payment cycles: Depends on the payment terms
Amount: 70 – 90% of invoice value
Invoice factoring is a type of debt financing where a “factoring company” buys a client invoice for a percentage of what is the total amount owed. The amount owed is then collected by the factoring company who does their best to collect the full amount.
Because it is based on money owed to the business versus the business owing the lender money, it is considered revenue-based debt financing as it is based on the revenue owed to the business.
Merchant cash advances
Payment cycles: Based on how fast you make sales
Amount: Varies based on the deal
Merchant cash advances are a type of revenue-based debt financing where a vendor, merchant, or lender provides a business with cash up front and collects a portion of each sale with interest until the debt is paid off. The lender is normally a supplier, buyer, or company familiar with the business that knows the sales cycles, so they feel confident they’ll get paid back.
Trade credit
Payment cycles: 30 – 120 days in pre-agreed upon terms
Amount: Situational
Trade credit is a debt financing where a supplier or vendor “trades” you products or services in exchange for payment at a pre-specified date normally a set amount of days. The set number of days is called net. If it is 30 days it is net 30, and net 90 means 90 days until payment is due. If payment is late, the agreement may enable the supplier to collect interest.
Mezzanine financing
Payment cycles: Terms normally in monthly increments
Amount: $1,000,000+
Mezzanine financing is a variation of a commercial loan where the lender gets partial ownership in the company until the debt is repaid. If the borrower defaults, the lender can take over part of the company versus seizing the assets listed as collateral. It’s most commonly used for mergers and acquisitions when there is insufficient capital like cash or high-value assets to cover the full cost.
Debt financing is an umbrella term for borrowing money when the borrower has a debt or transfers a debt owed to them to another party. It is one of the most common types of borrowing money or raising capital, and can be revolving or installment, and revenue-based.
National Funding does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
