What is debt financing? Types, costs and how lenders assess you

Debt financing is borrowing money for a business and paying it back, with interest, under an agreement. The lender has a claim to be repaid, but no ownership of the business and no share of its profits. When the debt and its costs are paid, the relationship ends.

That is the main difference from equity finance, where an investor buys shares and owns part of the company for as long as they hold them. With debt, you keep control and all future profits, but you take on a fixed obligation that must be met whether the business does well or not.

For a limited company, the company is the borrower. GOV.UK explains that a company is legally separate from its owners, who are responsible for its debts only up to the value of their investment. That protection is why lenders often ask directors for a personal guarantee. Our guide on how to get a business loan walks through applying step by step.

Debt finance comes in several shapes, each built around a different need. Our types of finance guides cover each one in depth.

Two specialist forms sit closer to equity investors. Mezzanine finance ranks behind senior debt and costs more, and venture debt lends to venture-backed companies alongside equity rounds.

The cost of debt is everything you repay above what you borrowed: interest plus fees. Lenders express it in different ways, as an APR, a flat rate or a factor rate, so compare offers on the total amount repayable.

• Interest. Fixed for the term, or variable and linked to a base rate. The Bank of England says that when it raises Bank Rate, banks usually increase what they charge on loans, so a variable-rate loan gets dearer.
• Fees. Arrangement, valuation, legal, security and sometimes exit or early repayment fees.
• Risk. The lender prices in how likely it thinks you are to repay, and what it can recover if you don’t.
• Security. A loan secured on property or assets is usually cheaper than an unsecured one, because the lender has something to fall back on.
• Term. A longer term lowers each payment but raises the total interest.

Our guide to business loan interest rates explains what moves the rate a lender offers you.

Security is what a lender can claim if you don’t repay. It may be a charge over a specific asset, a debenture over all the company’s assets, or a personal guarantee from a director. GOV.UK describes a charge as the security a company gives for a loan, and says it should be registered at Companies House within 21 days, after which it appears on the company’s public record.

Security also decides who is repaid first if a company fails. The Insolvency Service’s guidance explains that secured creditors are paid from the assets they hold security over, that a fixed charge ranks ahead of a floating charge, and that preferential debts are paid before the holder of a floating charge. Unsecured creditors share what is left.

Covenants are promises in the loan agreement. Financial covenants set tests the business must keep passing, such as a minimum interest cover ratio or a maximum level of borrowing. Other covenants might restrict further borrowing, dividends or selling key assets without consent. Breaking a covenant can let the lender demand repayment or change terms, even if every payment has been made.

Each lender sets its own criteria, but most look at the same questions:

• Can the business afford it? Turnover, profit and cash flow, from bank statements, accounts or connected banking data.
• How has it handled credit? The business’s and directors’ credit files, including any County Court Judgments.
• How established is it? Many lenders publish a minimum trading period.
• What is the money for? The purpose shapes the right product and the term.
• What happens if it goes wrong? Security, guarantees and the value of any asset.

Regulation depends on who borrows and how much. Under the Regulated Activities Order, credit over £25,000 provided wholly or mainly for business purposes is exempt from consumer credit regulation, and most lending to limited companies is not regulated consumer credit. Our page on why business loans get declined covers the common reasons for a no.

Debt works when the money will produce the cash to repay it: equipment that earns, stock that sells, a gap between paying suppliers and being paid. It works badly when the business is losing money, because repayments add a fixed cost to a business that cannot cover the costs it already has.

• If the problem is a tax bill, GOV.UK says you may be able to set up a payment plan with HMRC to pay it in instalments.
• If customers pay slowly, shorter payment terms or invoice finance may fix the timing without a new loan.
• If the spending will take years to pay back, equity or grants may fit better than a loan with monthly repayments.

Our guide to cash flow problems covers the options before borrowing.

Debt suits a business that can show it will generate the cash to repay. Equity suits a business that needs time to become profitable. Many use both. For the equity route, see our guides to angel investment and SEIS and EIS.

You can check your options with a soft search that does not affect your credit score; a lender’s full application may use a hard search.