Debt financing can simply mean borrowing money to finance your business with a promise to repay. It includes both secured and unsecured loans. Security involves a form of collateral as an assurance that the loan will be repaid. If the debtor defaults on the loan, that collateral is forfeited to satisfy payment of the debt.
Most lenders will ask for some sort of security on a loan. Few, if any, will lend you money based on your name or idea alone.
The advantages of debt financing are that the owner retains control in other words when you agree to debt financing from a lending institution, the lender has no say in how you manage your company and make all the decisions. The business relationship ends once you have repaid the loan in full. Secondly, you know well in advance exactly how much principal and interest you will pay back each month. This makes it easier to budget and make financial plans.
A lot of businesses in Uganda are using the method of debt financing to ably grow, however, without prior knowledge on how to handle loans it can be a nightmare because it opens one to a possibility of perpetual indebtedness, which is risky to businesses. While there are different loan products on the market, it is very important to know their features before you make a choice, for example, look at the loan size, evaluate yourself if you will be able to repay.
How about the interest rate? You need to know the straight line or flat rate and the declining balance. Knowing the difference helps you to make a right decision. My advice, however, to you is always look out for the declining balance, which calculates annual depreciation by calculating a depreciation rate and multiplying it by the remaining asset value. The advantage of using this method is that it accelerates the depreciation recorded early in the asset’s life.
Another advantage is that the accelerated depreciation reduces the taxable income and the taxes owed during the early years.
A disadvantage of this method is that the calculation is more complex. On the other hand, the straight line /flat method involves determining the cost to depreciate and dividing that amount by the number of years the company expects to use the asset.
The advantage of using the straight line method is the ease of calculating the annual depreciation amount. This method does not consider the rate the asset will actually depreciate in value.
One other key factor that one has to consider is financial discipline to make repayments on time. Exercise restraint (don’t borrow because others are borrowing, know exactly what you need) and use good financial judgment when you use debt.
A business that is overly dependent on debt could be seen as ‘high risk’ by potential investors, and that could limit access to equity financing at some point.
Do you have collateral you can use? Are you comfortable with using it? By agreeing to provide collateral to the lender, you could put some business assets at potential risk. You might also be asked to personally guarantee the loan, potentially putting your own assets at risk. It’s important to make this evaluation before you acquire any debt to avoid losing some or all of your property.
Are you able to qualify for debt financing and how is your credit history? If you have a good credit rating all this can help you to determine the type of loan and the affordable terms you can work around with, otherwise without this information and if debt is not handled with care the debt monster can be very dangerous.
Ms Annet Katusiime is a certified trainer in financial literacy.