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Mar 05, 2018 at 07:00 AM

Small Business Finance - How to Decide Whether You Need Debt or Equity Financing for Your Business

By Alexandra Trujillo
How to Decide Whether You Need Debt or Equity Financing for Your Business

When asking for funds for your business, it is important to know whether you need debt or equity financing. Things like the 5 C's can help you determine whether or not your small business even qualifies for bank debt. Depending on the speed your business os growing, you may need to adjust how you finance. While this may be a new concept to consider, this article does a great job in making sure to explain everything efficiently.

By Mark Abell

For small businesses, 2018 looks like a great time to expand. Corporate tax rates have been cut significantly, accelerated depreciation rules are encouraging capital investment, and the economy is showing signs of sustained strength.

The first question owners should ask is whether to use debt or equity to meet their capital needs. Let's start by looking at some common debt options: Conventional bank debt, SBA-guaranteed debt (my personal favorite, but not the best fit in every case), and factoring and other forms of non-bank lending.

Conventional debt for proven businesses

Getting the right type of financing begins with an honest assessment of the five C's: capital, collateral, conditions, creditworthiness and cash flow. These are the factors that banks use to determine if the business qualifies for bank debt.

Capital refers to the ratio of owner's equity to the firm's total liabilities (or leverage). While there are exceptions for certain industries, in most cases a business should have no more than $3 or $4 in liabilities (mostly debts and payables) for every dollar in equity to qualify for conventional financing.

Collateral refers to the assets that will secure the loan. Banks typically use a percentage of the current market value or cost of the assets (known as margin rates) to determine how much they can lend conventionally. For example, a bank may cap its term loan offerings to 75 percent to 80 percent of real estate and new equipment, and 50 percent of used equipment; and cap its lines of credit to 70 percent to 80 percent of current accounts receivable and 30 percent to 50 percent of finished goods inventory.

Conditions are market and industry conditions. If the company is highly cyclical or seasonal, or subject to significant regulations, it is generally more risky than other businesses and may have difficulty obtaining conventional loans.


Posted in Small Business Financing.

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