Pros and cons of debt financing during a recession

Funds are essential for maintaining and growing a business, particularly when the country is in a recession.

Whether to cover the costs of hiring and paying employees, investing in equipment, or waiting for customer payments, debt financing can be a way of managing cash flow.

Debt financing could help your business maintain a positive cash flow and cover necessary expenses and bills when faced with economic challenges, while also encouraging growth.

According to UK Finance's Business Finance Review, gross lending to smaller businesses through overdrafts and loans rose to £5.1 billion in the second quarter of 2022 – up from £4.9 billion in the first quarter.

What is debt financing?

Debt financing is when a business borrows money to raise capital to help cover costs or kickstart business growth.

There are a variety of debt finance options to consider if your business needs capital support, with examples including:

• bank loans – you may apply for a loan at a high-street bank
• overdrafts – a line of credit that lets you withdraw more than the funds available in your business bank account
• credit cards – a way to buy more significant purchases and spread the repayment costs
• friends and family – borrowing from friends or family may mean low or zero-interest repayments
• peer-to-peer crowdfunding – involves smaller businesses listing their business on a platform and attracting small loans from individuals.

Find out more about crowdfunding with our guide to peer-to-peer lending.

Advantages of debt financing

Debt financing could help you manage cash flow during a challenging economic downturn.

Other advantages include:

Control

Securing a business loan could help you stay in control of your business during difficult times.

How you spend the money you borrow is up to you.

In contrast, an angel investor or equity stakeholder may insist on having business input.

Tax deductions

Principal and interest payments on business loans are classified as business expenses and may be deductible from your business tax burden.

These deductions may be beneficial when running a business during an economic downturn.

Flexibility

Borrowing money from a bank can have flexible repayment terms that could help you with a realistic payback plan.

This could involve longer repayment terms, easing the pressure on your business.

Banks may also be flexible with the amount you borrow, allowing you to choose the optimum amount your business needs to get through a recession.

Low interest rates

Some bank loans, overdrafts, peer-to-peer funding, and even friends and family loans may offer low-interest rates.

Low-interest rates can help you save money and may help maintain your cash flow.

Fixed interest rates may mean you can benefit from knowing the exact payment each month, allowing you to manage finances and cash flow.

Disadvantages of debt financing

When considering debt financing there are several things to consider before taking out a loan.

Paying the debt back

Paying back a loan is part of the agreement, but during challenging times when funds are tighter, it's important to ensure you can pay back the agreed amount each month.

You should also be aware of any charges imposed for late or defaulted payments, which could add to the cost of the loan.

If you take a secured loan, your assets may be at risk if you cannot make repayments.

Impact on your credit rating

Your credit rating will be affected when taking a loan.

Your credit rating score can drop with each loan you take and can be negatively impacted if you default on repayments.

If your credit score drops too low, it may affect your chances of securing loans in the future.

High interest rates

A traditional bank or lender may increase their interest rates during the lifetime of a loan.

During periods of financial instability, banks may increase their interest rates on loans, potentially impacting your ability to make regular payments.

Some loans may also use your credit score to determine the interest rate.

If your credit score is low, it may negatively impact your loan's interest rate and make it harder for you to repay.

Is debt financing right for your business?

Before taking out a loan, consider the following to help decide if debt financing is right for your business:

• the ability to make regular payments – keeping on top of loan repayments is essential, as not making regular payments may negatively affect your business. Irregular sales or late customer payments may contribute to your inability to make regular repayments
• stage of your business – if your business is starting, you should consider if you'll be able to make the necessary repayments. The early stages of a business can produce less profit, so you may need to assess if you have enough each to cover the repayments
• do your customers pay on time – if you regularly chase customers for late payments, you may need to consider if taking out a loan is a viable option for your business. Due to cash flow challenges, irregular customer payments may see you default on loan repayments.

Alternative options to debt financing

If you decide debt financing isn't the right option for your business, other alternatives exist.

• grants
• angel investments
• government support
• equity finance.

Find out more about business grants in our guide.