What is debt financing? Overview, how it works, pros and cons

Debt financing is the process of borrowing money that must be repaid over a specific period with interest. It gives your business access to capital without giving up any ownership stake—you maintain full control of your company while accessing the funds you need.

It’s a fundamentally different approach from equity financing, where you trade ownership shares for capital. With debt financing, your relationship with lenders is purely transactional: They provide money, you pay them back according to agreed terms. They don't get a say in how you run your business or a share of future profits beyond the interest payments.

What is debt financing?

Debt financing means borrowing money from lenders to raise capital, which you agree to pay back with interest over time. It's a way to raise money for your business without diluting ownership or giving up control of company decisions.

When you use debt financing, you enter into a formal agreement with a lender, whether that's a bank, credit union, online lender, or bond investor. You receive a specific amount of money (the principal) and agree to repay it over a set period, plus interest as compensation for the lender's risk. Loans, bonds, lines of credit, and invoice factoring are all examples of debt financing.

Debt financing represents a strategic choice to leverage other people's money to grow your business while preserving your equity for yourself and existing shareholders. Unlike selling shares, where investors become part-owners, debt financing creates a creditor-debtor relationship that ends once you've repaid the loan.

How debt financing works in practice

The debt financing process is straightforward: You borrow money, agree to specific repayment terms, and make regular payments until the debt is satisfied. The legal agreement between you and your lender spells out every detail, from payment amounts and timing to what happens if you can't pay.

Securing debt financing

You’d typically follow these general steps to secure debt financing:

1. Determine your funding needs and repayment capacity: Assess how much capital you need and ensure your business can reliably service the debt
2. Choose the right financing option: Research short- and long-term loans, lines of credit, business credit cards, or bonds based on your goals and repayment capacity
3. Prepare your financial documentation: Gather your financial statements, sales information, business plan, and other information necessary to help secure the funding option you’ve chosen
4. Submit applications and negotiate terms: Submit your applications, compare the offers you get, and negotiate interest rates and terms to the best of your ability
5. Finalize the agreement and manage repayment: Sign the agreement, receive your funds, and make timely repayments on the debt according to the terms

Repayment schedules and covenants

Payment timing varies by loan type but follows a set schedule outlined in your loan agreement. Monthly payments are most common for term loans and credit lines, while bonds might pay interest semi-annually with the principal due at maturity.

Loan covenants are conditions you must maintain throughout the loan term:

• Financial covenants might require you to maintain certain ratios, like debt-to-equity or interest coverage
• Operational covenants could restrict major purchases, additional borrowing, or dividend payments without lender approval

Breaking covenant terms triggers a technical default, even if you're current on payments. Consequences range from higher interest rates and accelerated repayment demands to seizure of collateral for secured loans. Lenders include these provisions to protect their investment and ensure you maintain the financial health needed to repay the debt.

Interest calculation methods

Fixed interest rates stay the same throughout your loan term, making budgeting predictable. You'll pay the same interest amount each period regardless of market conditions, which protects you from rate increases but prevents you from benefiting if rates fall.

Variable rates fluctuate based on benchmarks like the prime rate, plus a margin based on your business creditworthiness. Your payments change as market rates move, creating uncertainty but potentially saving money if rates decline. Many variable loans include caps and floors to limit how much rates can change.

Interest typically accrues daily based on your outstanding principal balance, and your payment frequency determines when you pay the accrued interest. Some loans use simple interest (calculated only on principal), while others use compound interest (calculated on principal plus unpaid interest), which can significantly affect your total cost.

Types of debt financing

Businesses can access various debt financing options, each suited to different needs and situations. Understanding these options helps you match the right funding type to your specific requirements.

1. Term loans

Term loans provide a lump sum up front that you repay over a set period with fixed or variable interest. Banks, credit unions, and online lenders offer these traditional loans with terms typically ranging anywhere from 1–10 years for working capital and up to 25 years for real estate.

You'll typically need strong credit, stable cash flow, and potentially collateral to qualify for the best rates. Term loans work well for specific purchases like equipment or real estate where you know exactly how much you need. The predictable payment schedule makes budgeting simple, though prepayment penalties might apply if you pay off the loan early.

2. Lines of credit

A line of credit gives you flexible access to funds up to a predetermined limit. You only pay interest on what you actually borrow; you can draw funds as needed, repay them, and borrow again without reapplying.

Business lines of credit come in two forms: revolving (reusable after repayment) and non-revolving (one-time access). Interest rates are typically variable and higher than term loans, but this flexibility makes them ideal for managing cash flow gaps or unexpected expenses.

3. Bonds and notes

Bonds and notes are debt securities you sell to investors, typically for larger amounts than bank loans can provide. Corporate bonds might raise millions, with terms extending 10, 20, or 30 years.

These instruments pay investors regular interest, with the principal due at maturity. Investment-grade companies get better rates, while higher-risk issuers pay more through high-yield or "junk" bonds. The public bond market requires extensive disclosure and regulatory compliance, though private placements offer more flexibility for qualified companies.

4. Asset-based lending

Asset-based loans use your company's assets, like inventory, accounts receivable, equipment, or real estate, as collateral. Lenders typically advance 70–85% of receivables value or 50% of inventory value, adjusting the credit line as your asset values change.

This financing option works for companies with substantial tangible assets but inconsistent cash flow. Interest rates are usually lower than unsecured loans since the lender can seize your assets as collateral if you default. However, you'll face ongoing reporting requirements and audits to verify collateral values, adding administrative burden.

5. Invoice financing

Invoice financing lets you borrow against outstanding customer invoices, netting you immediate cash instead of waiting 30, 60, or 90 days for payment. Factoring companies buy your invoices at a discount, typically 80–90% of face value, then collect directly from your customers.

Invoice financing helps businesses with long payment cycles maintain steady cash flow. The cost depends on your customers' creditworthiness rather than yours, making it accessible even with poor credit. However, factoring fees can be expensive, ranging from 1–5% of the invoice value. And your customers will know you're using financing, which may affect your relationships.

Short-term vs. long-term debt financing solutions

Choosing between short-term and long-term debt depends on what you're financing and your repayment capacity. Each serves different business needs and comes with varying cost structures:

Advantages of debt financing

Debt financing offers several benefits that make it attractive for businesses seeking growth capital while maintaining control:

1. Preserved ownership

You keep 100% ownership and control of your company when using debt financing. Lenders have no say in your business decisions, hiring choices, or daily operations—they just want their payments on time.

Your equity stays intact for future needs, too. If you eventually need venture capital or want to sell the business, you haven't diluted your ownership stake with earlier financing rounds.

2. Predictable costs

Fixed-rate loans provide exact payment amounts for the entire term, making cash flow planning more straightforward. This predictability helps you make other financial commitments with confidence.

Variable-rate debt loses this advantage, but caps can limit your exposure. Even with fluctuating rates, you'll know your maximum possible payment, providing some certainty in your planning.

3. Tax benefits

The tax deductibility of interest payments effectively reduces your borrowing cost by your marginal tax rate. This benefit improves your return on investment when using debt to fund growth.

Consider a project returning 12% annually. If you fund it with 8% debt and you're in a 25% tax bracket, your after-tax cost is only 6%, doubling your spread from 4% to 6%.

Disadvantages and risks of debt financing

While debt financing preserves ownership, it creates obligations and risks that can threaten your business if you don’t manage it carefully:

1. Cash flow pressure

Debt payments are due regardless of your revenue or profitability. A slow month doesn't excuse you from making your $10,000 loan payment—that money needs to come from somewhere.

This inflexibility can force difficult decisions during downturns. You might delay hiring, cut marketing spend, or postpone equipment maintenance to meet debt obligations. These short-term fixes can harm long-term growth.

2. Collateral requirements

Secured loans put your assets at risk if you can't repay. If you took out a loan to expand hiring and used your equipment as collateral, the lender can seize it if you miss too many payments, crippling your operations.

Personal guarantees on business loans put your individual assets on the line, too. Your house, car, and savings could be at risk if your business fails to meet its obligations. Even unsecured debt often requires blanket liens on all business assets. While less specific than equipment financing, these liens still give lenders a claim to your assets in the event of a default.

3. Potential for default

Missing loan payments triggers serious consequences. On top of late fees, your credit rating suffers, making it more difficult or expensive to get financing in the future.

Loan covenants create additional default risks beyond payment issues. Violating financial ratios or operational restrictions can trigger a technical default, which accelerates the entire loan balance due immediately.

Default can force bankruptcy or liquidation in severe cases. Even if you avoid that extreme, the reputational damage with suppliers, customers, and other stakeholders can take years to repair.

Debt financing vs. equity financing

Choosing between debt and equity financing is one of the most critical decisions you'll make for your business. Each path offers clear pros and cons that affect everything from daily operations to long-term strategy:

Debt financing examples and use cases

Different business situations call for different financing approaches. Here are some concrete scenarios where debt financing often makes the most sense:

1. Equipment purchase

Financing machinery or technology with the asset as collateral is one of the most straightforward use cases for debt financing. For example, say you run a machine shop. You buy a $200,000 CNC machine that will generate revenue for 10 years. Matching your loan term to the asset's useful life aligns costs with benefits.

Equipment financing typically offers lower rates since the asset serves as collateral. If you default, the lender can repossess and sell the equipment to recover their investment. This security allows them to offer lower rates than unsecured loans.

The predictable revenue generated from equipment makes debt service manageable. You know the machine will produce 1,000 units monthly at $50 profit each, easily covering your $3,000 monthly payment while generating positive cash flow.

2. Expansion into new markets

Using debt to fund growth while maintaining ownership makes sense when you have a proven business model. Opening a second location, launching in a new market, or adding product lines leverages your existing success without diluting equity.

A restaurant chain might use a term loan to open three new locations, knowing each store generates predictable returns based on the flagship's performance. Your debt payments are covered by new revenue streams while you keep all the upside.

This approach works best when you have strong cash flow from existing operations. Your current business covers the debt service during the expansion's ramp-up period, reducing risk while you scale.

3. Bridging seasonal cash gaps

Short-term financing helps businesses with cyclical revenue patterns maintain operations during slow periods. A landscaping company might use a line of credit to cover payroll and expenses during winter months, repaying it during the busy spring and summer seasons.

Invoice financing works well for B2B companies with long payment cycles. If customers pay in 60–90 days but suppliers demand payment in 30, factoring receivables provides immediate cash flow without taking on traditional debt.

These temporary financing solutions tend to cost more than long-term debt but provide flexibility exactly when you need it. The key is matching the financing term to your cash flow cycle, ensuring you can repay debt when revenue returns.

Get the funding you need with Ramp

Traditional debt financing options like bank loans and invoice factoring can offer you the money you need for growth, but in some cases, the risks might outweigh the rewards. Ramp's corporate cards are a smart alternative.

Unlike traditional debt financing options, which often require personal guarantees or a strong credit history, Ramp bases your approval on business fundamentals. All you need to qualify is a registered business with an EIN and at least $25,000 in a U.S. business bank account.

Ramp also comes with tools to spend your capital smarter. Built-in expense management features automatically track and categorize your transactions in real time, and custom spending limits help you control expenses at the point of sale.

Try an interactive demo and see why companies that use Ramp save an average of 5% a year across all spending.