The cash flow struggle for growing businesses is real, leaving many companies to seek out a simple way around this problem via debt financing.
Done right, debt financing can help online sellers optimise existing products, expand sales channels, and enter more territories. For some companies, this type of financing can even be the catalyst for exponential growth.
Trouble is, there’s a lot of confusion surrounding debt financing, what it does, and whether it’s safe for ecommerce businesses to use. To get you up to speed, we’ll reveal the must-know details on debt financing, and how to make it work for you. Let’s dive in.
The Scoop on Debt Financing
- What Is Debt Financing?
- The Unfiltered Pros and Cons of Debt Financing
- Simple Ways to Prepare for Debt Financing Success
- 3 Must-Know Debt Financing Metrics
Ready to start your ecommerce funding journey? Discover how SellersFunding can help.
What Is Debt Financing?
There are a ton of pros to debt financing… and a few must-know cons.
When it’s done right, businesses can use the cash raised to fund existing operations, launch new products and expand into new territories.
But to get your hands on debt financing, it will cost you.
Debt financing definition: Debt financing is when a company sells debt instruments like bonds, bills and notes to financial institutions or retail investors to raise capital. The investors receive interest or coupon payments on top of the initial sum borrowed.
Many debt financing providers require you to cough up collateral (usually company assets) to secure funding. So, before you consider it as an option, it’s essential your business has the following fundamentals in place:
- Healthy revenue
- Stable cash flow
- Positive valuation
- Sufficient assets
Note: Debt financing differs from equity financing, which involves selling stakes in the business for funds. Unlike equity financing, debt financing is not permanent, so the business won’t have ongoing financial or legal obligations to its investor(s) once the agreed amount has been paid. As always, be sure to seek professional legal advice before entering into any type of debt financing agreement.
The Unfiltered Pros and Cons of Debt Financing
Debt financing can be a great way to fund your store — but that doesn’t mean it’s always easy (or right for your business).
To help you decide whether taking on debt is right for you, let’s get into some specific pros and cons:
Pros of debt financing ✔️
- Retain business ownership: With debt financing, you don’t have to give up any ownership in the business you’ve worked so hard to build. This means you still receive all proceeds if you decide to sell in the future.
- Debt payments are tax-deductible: That’s right. Debt financing can actually reduce your tax obligations because in most cases you can claim them against your tax bill. Nice! 🙌🏼
- Debt financing is cheaper than equity financing: Debt can be more affordable than equity and you can take out a small debt financing sum and flip it into huge returns.
Cons of debt financing ❌
- Interest payments hang over your head: Nothing in life is free, and debt financing is no exception. You’ll be responsible for paying investors interest payments, which can add up.
- You’ll have repayment obligations no matter what: Slow month? Found a new opportunity you want to take on? You’ll need to make sure your cash flow can cover the rough patches and projects, to hit all those regular repayments.
- Debt financing is risky if your cash flow is rocky: Since you’ll have to make regular repayments, you could end up needing to take out more debt or even defaulting on your debt financing repayment. This can have devastating effects like collateral forfeiture, steep penalties or credit rating damage.
Think debt financing might not be for you? Explore alternative ecommerce funding options.
Simple Ways to Prepare for Debt Financing Success
Establish what you need and can afford
If you want to be successful with debt financing, first you need to know how much capital you need and can afford. (Note: your sales should be able to cover interest payments and repayments to meet this bar comfortably.)
To figure out if debt financing is for you, it’s helpful to know what you need the money for. If you’re looking for a huge cash deposit to take on multiple territories at once, debt financing may be the one, but if you want to refinance existing debt, a credit limit similar to a flexible working capital solution might be a better option.
Pick the right debt financing investor
Due diligence is the name of the game here — because just like in any business deal, you need to ensure your investor and your business are a great match.
Research the prospective investors’ past investments, satisfaction rates and success rates to uncover their specialties. It’s best if your investor has the knowledge and resources to help you invest the capital efficiently.
To increase your odds for success, ensure your investor:
- Understands ecommerce
- Provides fair rates and repayment terms
- Can offer business guidance and support
Invest your debt financing on proven projects
To increase your chances of getting a return on your investment, dedicate most of your debt financing towards projects and products that have been road-tested and passed.
A cautious approach will ensure you don’t gamble away money on things that haven’t proven their worth. Plus, when you back products and projects that are doing well, you can accelerate their progress even more.
3 Must-Know Debt Financing Metrics
Now for the number crunch.
Because debt financing isn’t for everyone, it pays to take a hard look at your numbers to help you figure out if it makes sense for your company.
These three key metrics will help you know if debt financing is for you:
- Cost of Debt
First off, you need to know the Cost of Debt. This is the typical interest rate your business pays on all its debts each year, and it helps investors decide whether your company is a safe bet or too risky to invest in. Your Cost of Debt also provides a benchmark to determine whether investing the borrowed money would be a profitable move for your business.
For example, say you want to launch a new product line that would increase your revenue by 9%, and the debt you want to take on will cost 6% — this could be a green flag. The rule of thumb is: if your Cost of Debt exceeds the additional cash the investment will bring in, it’s a no-go. 👎🏻
Let’s break down how to calculate your Cost of Debt:
- Work out how much your total interest obligation is for the year by multiplying the interest percentage by the loan amount.
- Add up your business debts.
- Divide the total interest by total money borrowed to get your Cost of Debt
Total Annual Interest / Total Debt Amount x 100 = Cost of Debt
For example, a Cost of Debt calculation could look like this:
- Debt 1: $20,000 with a 4% interest rate
- Debt 2: $5,000 with a 5% interest rate
- Annual interest: ($20,000 x 4%) = $800 + ($5,000 x 5%) = $250 = $1,050
- Cost of Debt = $1,050 / $25,000 x 100 = 4.2%
Note: If your borrowing isn’t consistent throughout the year, a year-based calculation might not provide a true representation of your store’s Cost of Debt. If this is the case, you can calculate your Cost of Debt on a quarterly basis to increase accuracy.
Once you have your Cost of Debt, you now need to work out your After-Tax Cost of Debt. Your answer should be lower than your Cost of Debt, because taxes are tax-deductible.
Here’s the formula for After-Tax Cost of Debt:
Annual Interest Rate (1 – Tax Rate) = After Tax Cost of Debt
Using the example above, your After-Tax Cost of Debt would look like this:
- 4.2% (1 – 20%)
- 4.2 x 0.80 = 3.36%
2. Interest Coverage Ratio
Next up is the Interest Coverage Ratio (ICR). This metric reveals how well your business can repay the interest on its existing debts. The end figure dictates how many times your store can cover interest payments.
Here’s the formula for working out your ICR:
Earnings Before Interest and Tax (EBIT) / Interest Charges = Interest Coverage Ratio
*Note EBIT = Revenue – Cost of Goods Sold – Operating Expenses
So, working out your ICR could look like this:
- Revenue: $125,000
- Cost of Goods Sold: $35,000
- Operating Expenses: $10,000
- EBIT: $125,000 – $35,000 – $10,000 = $80,000
- Total interest: $3,000
- ICR: $80,000 / $3,000 = 26.67
3. Debt-to-Equity Ratio
Finally, let’s take a look at the Debt-to-Equity Ratio (a.k.a. Gearing, Debt-Equity Ratio or Risk Ratio). This assesses the total debt obligations against your business’ share capital and kept earnings (Shareholders Equity).
Sounds complicated, but bear with us.
The Debt-to-Equity Ratio uncovers whether your company is more reliant on debt or equity financing. Investors tend to prefer a lower Debt-to-Equity Ratio as it demonstrates the company doesn’t have huge interest obligations, can make repayments using company-generated cash, and can grow by reinvesting profits.
In other words, this one shows investors whether you’re worth their time and dollar.
It’s worth remembering that in some instances, a higher Debt-to-Equity Ratio can be profitable since debt is more cost-effective than equity. But there’s a caveat. If your company’s Debt-to-Equity Ratio gets too high, your business may not be able to cover the expense, and things like equity costs will rise.
Here’s the formula for calculating your Debt-to-Equity Ratio:
Short-term Debt + Long-term Debt + Additional Fixed Payment Obligations / Shareholder Equity
In play, the Debt-to-Equity Ratio could look like this:
- Short-Term Debts: $5,000
- Long-Term Debts: $20,000
- Other Fixed Payments: $6,000
- Shareholder Equity: $18,000
- $5,000 + $20,000 + $6,000 / $18,000 = 1.72
Profitable Debt Financing Can Be a Reality (If You Tread Carefully)
Debt financing is a tough nut to crack, but if you get it right, it can take your ecommerce store to new heights.
Uncovering which debt financing avenue is most appropriate for your store’s current situation and future goals ain’t easy — but trust us, the more research you do, the more it will pay off.
And if you decide debt financing isn’t for you, it doesn’t have to end your ecommerce funding journey — there are still plenty of flexible options available for you to tap into.
Looking for a flexible funding solution? Find out SellersFunding can help.
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