A debt means borrowing money from an external source with an agreement to pay the principal at a future date along with the interest. It is often the preferred route for start-up companies to raise finances for operations. Even the healthiest of the corporate balance sheet will reflect some degree of debt. While banks remain the best source for debt financing, private companies or individuals like family members or friends are the other options.

Pros of debt financing

• No dilution of ownership- You are contractually obligated to repay the debt on the decided due date, but there is no dilution of ownership or external control in the operations of the business. You are at liberty to take all decisions in critical matters of the company.
• Tax deductions – The government directly helps corporations and businesses, as they are the engines of growth in any economy. As such, one big advantage that companies enjoy is tax deductions on the principal amount and interest payments when it comes to the cost of borrowing. The company can call the loan amount and the interest payments “business expenses” and deduct it from their income. It is prudent to think of Uncle Sam as a partner in your business with his stake equivalent to whatever the business tax rate may be.
• Lower interest – A prudent director carefully analyses the effect of tax deductions on the interest rate of the bank. A bank usually charges around 10% on the loan as interest and the government usually charges around 30% as tax, so there could be a great advantage to taking loans you could deduct.

Cons of debt financing.

• Paying back the loan – It is important to understand that you will have to continue to make interest payments on the loans even if there is a recession in the market or the business is going through a rough patch. Furthermore, if the company goes bankrupt, the creditor will enjoy priority when it comes to repayment.
• Interest rates – While a company may enjoy discounted rates because of tax deductions, a number of factors influence the interest rates. These include the larger macroeconomic factors prevailing in the country, credit reports, history with the banks, and the business credit rating, which may quickly go against you.
• Credit report – Through a process known as “levering up”, each subsequent loan that the company takes to raise finances increases its risk profile. Therefore, the company will be judged as a greater liability and the rate of interest will increase with each subsequent loan. This will reflect on your credit report and will affect your creditworthiness.
• Collateral – You will have to be quite sure that the business can raise adequate finances to repay the investors on the due date. Therefore, even if you are investing in a valuable asset, you must be sure that you will generate a sufficient cash flow to pay the interest. Also, you will be asked to put up some form of collateral as a guarantee in the event you default on payments.