While we believe that debt capital is a useful tool for a business to take advantage of, a key piece of understanding is the application of the capital. At a high level, there are two general applications that companies should consider. Using debt capital to finance working capital could be applicable to any company, but using debt capital for asset financing will apply to only a subset of all companies. We use the term Asset Finance to describe companies who are in the business of originating financial assets themselves.
Working capital finance
A business usually needs working capital finance for the following activities:
Hiring: when needing to have a larger team to complete a large project even before the revenue from the project materializes.
Marketing: in early stages, marketing for a product is essential for it to reach potential customers.
Sales: similar to marketing, sales activities are also necessary to streamline the process of delivering the product to the customers.
Product development: whenever we develop a new product, trials and errors are unavoidable, making the process costly. Not only that, creating multiple prototypes is also important to test which one brings the best customer experience.
Inventory (pre-scale): once we have our official product, it is also necessary to have inventory stocked for future sales which should be in alignment with our forecast.
Cash flow gaps: sometimes the timing of cash inflows and outflows can be different, we need to have funds to fill in the gap or it can soon turn into a bigger issue, leading to business failure.
Asset finance
On the other hand, asset finance is usually required in the following cases:
Consumer lending: focused on individual and household consumers. It comprises loans for homes and cars as well as personal loans given to borrowers who utilize the money for their own or their families' needs.
Commercial lending: when a business takes out a loan to cover operating costs, real estate purchases, or equipment purchases necessary for growth.
Receivables finance: when a company obtains capital based on issued invoices, this is known as receivables financing. Those invoices correspond to purchases that have been made, but for which no payment has yet been made.
Real estate: A real estate investor can get finance for a rental property through the asset-based lending method. This kind of loan is determined by the borrower's liquid assets and credit score, not by their income or job history.
Inventory (at scale): Think about large businesses like E-commerce and wholesalers where running out of inventory could leave your reputation tarnished. With asset financing, not only could you avoid the gap in your cash conversion cycle, but also free up capital tied up in your inventory.
Why might it make sense to use debt to lever your business up to spend on these categories. If there are functions that are net positive then using leverage may make sense.
