Having written “Understanding Life Cycle Financing- What an entrepreneur should know” and “Financing Entrepreneurial Ventures—What an Entrepreneur needs to know” , I find it quite interesting to publish this article “Understanding Debt Financing- What an Entrepreneur Should Know”. The aim is that an intending entrepreneur or an active entrepreneur could maximize the resource information present to the progress of his business.

Debt financing is an important and ambiguous word in the world of entrepreneurship. What is Debt Financing?

Debt financing is a financing method involving an interest-bearing instrument usually a loan, the payment of which is only indirectly related to the sales and profits of the business. Another name for debt financing is asset-based financing, and it requires that some asset (such as motor vehicles, plant and machinery, land and buildings, etc.) owned by the business be used as collateral.

Debt financing puts an obligation on a entrepreneur, because debt financing requires the entrepreneur to pay back the amount of funds borrowed plus a fee usually expressed in terms of a percentage of the amount of funds borrowed (called the interest rate). There can also be an additional fee (sometimes referred to as “hidden charges”) which is often considered for using or being able to borrow the money. If the financing is short term (that is, less than one year), the money is usually used to provide working capital to finance stock, trade debtors, or the operation of the business. The funds are typically repaid from the resulting sales and profits during the year. Long-term debt (that is, more than one year) is frequently used to purchase some assets such as motor vehicles, land and building plant and machinery, etc with part of the value of the asset (usually 50 to 80 percent of the total value) being used as collateral for the long term loan. Particularly, when interest rates are low, debt (in contrast with equity) financing allows the entrepreneur to return a larger ownership portion in the business and have a greater return on the equity.

Careful attention must be made by an entrepreneur when on dent financing. An entrepreneur must be careful so that the debt does not become so large that regular interest payments become difficult if not impossible to make, a situation that will inhibit growth and development and possibly lead to bankruptcy.