What is debt financing and how does it work?

Debt financing is one of the most common ways for businesses to access capital. Each year, UK businesses secure billions of pounds in funding to support and grow their operations. Some do this through traditional bank loans, some use business credit cards, and some choose specialist products like asset finance or invoice financing.

If you’re looking to grow your business, boost your cash flow, or invest in new equipment, debt financing could be the answer. It lets you borrow money that you repay over time, with interest, without giving up ownership of your business.

In this article, we’ll explain what debt financing is, how it works, the different types available, how to decide if it’s the right choice for your business, and alternatives to consider if debt isn’t the best fit.

Key points:

• Debt financing means borrowing money from a lender (eg. a bank or government-backed scheme) and repaying it over time with interest

• Unlike equity financing, where you sell shares in your business, debt lets you keep full control

• Funding Options by Tide can help you compare options and find the right financing solution for your needs

What is debt financing?

Debt financing is a way to borrow money for your business, which you then repay (with interest) over an agreed period. It’s a popular way for businesses to fund growth, manage cash flow, or invest in assets because it’s straightforward and predictable. You simply agree on the amount, the repayment term, and the interest rate, and then pay it back in instalments.

Unlike equity financing, where you give up a share of your business in exchange for funding, debt financing allows you to keep full ownership.

How does debt financing work?

When you take on debt finance, you’ll agree on three key things:

• The amount: How much you can borrow

• The term: How long you have to repay it

• The cost: The interest rate and any fees

You can access the funds as a lump sum (like a term loan) or as a flexible facility (like an overdraft or invoice finance), depending on the type of debt financing you choose.

When submitting your application, the lender will assess your business’s financial health, credit history, and ability to repay. The whole process can take between a few days to several weeks, depending on the type of financing and the lender’s requirements.

Secured vs unsecured debt

Debt can be secured or unsecured:

• Secured debt is backed by assets like property, vehicles, or equipment. If you can’t repay the debt, the lender can sell your assets to recover their money. Secured debt often has lower interest rates because it’s less risky for lenders.

• Unsecured debt doesn’t require you putting assets on the line. Instead, lenders rely on your creditworthiness and may ask for a personal guarantee. Unsecured debt is quicker to arrange, since the lender doesn’t have to value and secure assets, but it usually costs more due to being considered higher risk.

Calculating the cost of debt

Debt financing impacts your bottom line. So before arranging financing for your business, it’s important to figure out how much it will actually cost you.

The cost of debt is typically expressed as an interest rate, but you should also consider any fees or charges. To compare options, you can calculate the pre-tax cost of debt (the average interest rate you’ll pay) and the after-tax cost of debt (which accounts for tax relief on interest payments).

Here’s the formula for pre-tax cost of debt:

Pre-tax cost of debt = (Total debt outstanding / Total interest expense​) x 100

For example, if you pay £10,000 in interest on a £200,000 loan, your pre-tax cost of debt is 5%. If your tax rate is 20%, your after-tax cost of debt would be 4% (because you save 20% on the £10,000 interest as tax relief), since interest payments are tax-deductible.

Who is debt financing for?

Debt financing works well for businesses that:

• Have reliable cash flow to cover repayments

• Want to retain full ownership of their business

• Need funding for a specific purpose, like buying equipment or expanding

It’s commonly used by established SMEs, asset-heavy businesses (like manufacturing or logistics), and start ups with strong plans – particularly those backed by government schemes.

What types of debt finance are there?

There are several types of debt financing options to consider, each designed for different business needs.

• Business loans: A lump sum repaid over a fixed term, often used for big investments like equipment or expansion.

• Overdrafts and revolving credit: Flexible funding for short-term cash flow needs.

• Asset finance: Funding tied to specific assets, like vehicles or machinery. You can choose between hire purchase (own the asset at the end) or leasing (use the asset without ownership).

• Invoice finance: Advance cash against unpaid invoices to improve cash flow.

• Government-backed schemes: Like the Growth Guarantee Scheme (GGS), which offers lower-risk lending with government guarantees.

• Start Up Loans: Personal loans for new businesses, with mentoring included.

What can you use debt financing for?

Debt financing is incredibly versatile and can be used for a wide range of business purposes, including:

• Buying vehicles, machinery, or equipment

• Funding marketing or hiring new staff

• Bridging cash flow gaps during growth or seasonal dips

• Refinancing expensive short-term borrowing

Examples

• A construction business might use a hire purchase agreement to finance a new excavator, spreading the cost over five years while using the machine to generate revenue.

• An online retailer could use invoice finance to free up cash tied up in unpaid invoices, allowing them to restock inventory before busy sales periods.

• A tech start up might apply for a Start Up Loan to cover initial costs like software development and office space while they build their customer base.

What are the benefits of debt financing?

• Retain ownership: Unlike equity financing, you keep full control of your business while still accessing the funds you need to grow

• Predictable costs: Fixed repayments make budgeting easier, as you’ll know exactly how much you need to pay each month

• Tax efficiency: Interest payments are usually tax-deductible, which lowers your overall cost of borrowing and improves cash flow

• Faster growth: Borrowing lets you invest in opportunities sooner than waiting for profits, helping you scale faster without diluting ownership

What are the downsides of debt financing?

• Fixed repayments: You’ll have to repay the debt even if your business struggles, which can put pressure on your cash flow

• Interest rate risk: While most financing is done using fixed interest rate products, choosing a variable rate product (where rates can go up or down depending on market conditions) can increase your costs unexpectedly – some lenders also offer flexible‑rate or hybrid products, so check the specific terms

• Personal guarantees: If you default, you’ll be personally liable for the debt, putting your personal assets at risk

• Covenants: If your business doesn’t hit certain targets, some lenders may impose restrictions on how you run your business, such as limiting additional borrowing or requiring approval for major expenses

Alternatives to debt financing

If debt financing isn’t suitable or you simply prefer not to take on debt, you could consider:

• Equity finance: Instead of borrowing, you sell shares in your business to investors, meaning no repayments but you’ll have to give up some ownership and control

• Grants and subsidies: Unlike loans, these don’t need to be repaid, but they’re often competitive and restricted to specific uses or industries

• Revenue-based finance: Repayments flex with your revenue, making it less risky than fixed debt repayments if your income fluctuates

• Supplier or customer finance: Negotiate better payment terms with suppliers or ask for upfront deposits from customers to improve cash flow without taking on debt

Lots of businesses use a mix of options at different stages as their needs change. So it’s also worth exploring whether a combination might work for you.

Is debt financing right for your business?

Debt financing isn’t the only way to fund your business growth. And in some cases, it might not be the best fit for your situation.

To decide whether debt financing is right for you, ask yourself:

• Can you afford the repayments? Make sure you’ve run the numbers and tested different scenarios. If you can’t comfortably meet the repayments, debt financing might not be the right choice.

• What’s the purpose? Match the funding type to your needs (eg. using long-term loans for big purchases, and revolving facilities to boost your working capital).

• Are you comfortable with the risk? Personal guarantees can provide security for lenders but put your personal assets on the line. Consider whether you’re willing to take on that risk.

• What are the alternatives? Weigh up the pros and cons of debt financing against other options like equity or grants.

If you’re unsure, it can be worth speaking to an accountant or finance broker for advice.

Explore debt financing with Funding Options by Tide

At Funding Options by Tide, we specialise in helping UK businesses find the right financing solutions. Whether you’re looking for a term loan, asset finance, or something more specialist, we can help you compare options and secure the funding you need.

We’ve already helped over 19,000 businesses secure more than £1.1 billion in finance. We work with a panel of trusted lenders, so you can compare options and apply in one place. Checking your eligibility is free, takes just a few minutes, and won’t affect your credit score.

Compare your financing options with our range of business loans.

FAQs

How much does debt finance cost?

The cost of debt finance varies depending on the type of financing, the lender, and your business’s financial health. Secured loans typically have lower interest rates because they’re less risky for lenders, while unsecured loans and credit cards tend to be more expensive. Always compare the total cost, including interest and fees, before committing.

How much can I borrow?

The amount you can borrow depends on your business’s financial situation, the type of financing, and the lender’s criteria. For example, under the Growth Guarantee Scheme, businesses can borrow up to £2 million in Great Britain or £1 million in Northern Ireland, while Start Up Loans offer up to £25,000 per person (with a maximum of £100,000 per business).

Will I need a personal guarantee?

Many lenders require a personal guarantee for unsecured loans or higher amounts. This means you’ll be personally liable if the business can’t repay the debt. It’s important to understand the implications before agreeing to a personal guarantee as it can significantly affect your own finances.

Can start ups access debt finance?

Yes, but your options may be more limited. Start Up Loans are designed specifically for new businesses, offering funding and mentoring. Some alternative lenders also cater to start ups, but you’ll likely need a strong personal credit profile and a solid business plan to qualify. Government-backed schemes can also make it easier for start ups to access financing.

Please note that the information above is not intended to be financial advice. You should seek independent financial advice before making any decisions about your financial future.

It’s important to remember that all loans and credit agreements come with risks. These risks include non-payment and late-payment of the agreed repayment plan, which could affect your business credit score and impact your ability to find future funding. Always read the terms and conditions of every loan or credit agreement before you proceed. Contact us for support if you ever face difficulties making your repayments.

Funding Options, now part of Tide, helps UK firms access business finance, working directly with businesses and their trusted advisors. Funding Options are a credit broker and do not provide loans directly. All finance and quotes are subject to status and income. Applicants must be aged 18 and over and terms and conditions apply. Guarantees and Indemnities may be required. Funding Options can introduce applicants to a number of providers based on the applicants' circumstances and creditworthiness. Funding Options will receive a commission or finder’s fee for effecting such finance introductions.