Debt Financing - What is It?
Debt financing is a way of funding your business through borrowing money. Many businesses finance their operations and supplies through borrowing money from a lender. There are long-term debt financing and short-term debt financing options. Many pros and cons are associated with debt financing including the ability to retain control over the decisions involved with one’s company (pro) and the fact that many debt financing options may come with a high cost (con). One of the most important considerations, when funding your business through utilization of debt financing options, is how debt financing affects the balance sheet.
Debt and the Balance Sheet
On the balance sheet, debt financing is accounted for under the “liabilities” section. Your short-term debt financing will be accounted for - only the unpaid portions - under “current liabilities.” Long-term debt, on the other hand, will be accounted for under “long-term liabilities.”
All traditional or conventional loans your business has used to finance its operations go under liabilities, but, there are a couple of debt financing options that do not go on your balance sheet. These are called “off-balance sheet” financing options. According to 1st commercialcredit.com, there are two types of off-balance sheet financing: equipment leasing and factoring. Equipment leasing makes it so that your company can acquire equipment through renting it. Factoring, or financing through a company’s accounts receivable, makes it so that the business can purchase equipment, without having these purchases count against your bottom line.
How Debt Financing Affects Balance Sheets
Debt financing affects balance sheets in two major ways. First, because it’s a liability, debt financing detracts from the overall equity of your company. For instance, if your company makes $50,000 one year, but owes $100,000, your owner’s equity will be $-50,000. That’s an awful lot of money to be in the hole! It’s important to be aware that debt financing detracts from the owner’s equity in a company, because financing too much can create problems with cash flow down the line.
A second way that debt financing affects the balance sheet is that it allows potential lenders and investors to view your debt-to-worth ratio in relation with the entirety of your business’s health. If your company has a very high debt-to-worth ratio, lenders are going to be leery of giving you money, and you should be worried about your company. A high debt-to-income ratio, as displayed on the balance sheet, can create too much of a burden for your company. This ratio is determined by dividing the company’s total liabilities by the company’s tangible net worth. Tangible net worth is determined by subtracting liabilities and intangible assets such as copyrights, patents, etc. A lower ratio means that a company is more stable and is more capable of obtaining money through debt financing in the future, a really high ratio means that a company is in danger of being torn apart by creditors.
It is important to understand the way that debt financing will affect your balance sheet. Be aware that for small businesses a debt-to- worth ratio that is higher than 60 percent is cause for great alarm; in large businesses this figure increases to about 75 percent. It is absolutely vital for your company to keep the ratio as small as possible, and not to take out further loans if you’re crossing the 50 percent threshold.
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