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Net income and EBITDA (earnings before interest, taxes, depreciation, and amortization) are both measures of business earnings. But they are not the same thing.

Net income refers to earnings of a business during a certain period after subtracting all expenses incurred by the company. EBITDA is similar, but doesn’t subtract certain expenses (such as interest paid on debt and non-cash depreciation expenses) from total revenues. As a result, EBITDA is generally higher than net income.

If you own your own small business, it can be a good idea to know both metrics, since each convey different messages about your firm’s profitability. Lenders may also review both numbers if you apply for a small business loan.

Here’s a closer look at net income vs. EBITDA, how these earnings metrics are similar and different, and what each can tell you about your company’s financial health.

💡 Recommended: Business Income Statements

What Is EBITDA?

EBITDA stands for earnings before taxes, interest, depreciation, and amortization. It’s a measure of a company’s earnings that factors in the cost of goods sold (COGS); selling, general, and administrative (SG&A) expenses; and other operating expenses.

However, EBITDA doesn’t subtract costs that are not directly related to the company’s operations, namely interest paid on small business financing, amortization/depreciation expenses, and income taxes on business revenue.

As a result, EBITDA can be useful for assessing a company’s income potential, as well as comparing the relative performance of two firms in the same industry that may have different tax liabilities and capital structures.

Here’s a deeper look at what EBITDA excludes and why.

•  Interest: This refers to interest on debt, including all types of business loans. EBITDA excludes it because how much debt a company takes on will depend on the financing structure of a company. Different companies have different capital structures and, as a result, different interest expenses.

•  Taxes: Two companies with identical sales numbers could pay significantly different small business taxes, depending on where they are located and how many deductions they have. Therefore, taxes do not illustrate a company’s financial performance or revenue potential.

•  Depreciation & Amortization: Depreciation and amortization involve spreading out the cost of an asset over the course of its useful life. While depreciation and amortization are real costs, they depend on the firm’s historical investments, not its current operating performance.

What Is Net Income?

Net income is simply the revenue a business brings in once all costs related to operating the business are subtracted.

Those costs include COGS, SG&A expenses, taxes, interest expenses, non-cash charges, among others. To calculate net income, you take the gross income — the total amount of money earned — for an accounting period, then subtract all expenses incurred by the business during that period.

Net income is found at the bottom of a company’s income statement, which is why it’s often referred to as a company’s “bottom line.”

How EBITDA and Net Income Are Related

Many of the factors that impact EBITDA also impact net income. For example, both metrics start with a firm’s total revenues. And both subtract business expenses (including COGS and SG&A expenses) to determine a firm’s profits.

To calculate EBITDA, analysts will typically start with net income then add back interest, taxes, depreciation, and amortization to arrive at EBITDA.

Comparing EBITDA vs Net Income

Let’s dig into some of the key similarities and differences in EBITDA vs. net income. While the nuances might seem minor, they can add up to a significant difference in terms of final numbers.

Similarities

There are several similarities between EBITDA and net income. Both metrics:

•  Are used to measure the earnings and profitability of a company

•  Take most of the major costs of doing business into account

•  Are used by investors and lenders to gauge the financial health and income potential of a business

Differences

There are also some key differences between EBITDA and net income. These include:

•  Net income subtracts taxes, interest paid on debt, and amortization/depreciation expenses from total revenues; EBITDA does not.

•  EBITDA is used to determine the total earning potential of a company, whereas net income is used to determine the company’s earnings after all expenses are paid.

•  Net income is often used to understand the financial health of mature companies, while EBITDA is commonly used to evaluate start-ups.

•  EBITDA is generally more useful than net income to compare the financial health of companies in the same industry.
Net income is accepted by the generally accepted accounting principles (GAAP), whereas EBITDA is not.

•  EBITDA can overstate the earnings of a business by omitting real expenses, whereas net income cannot.

Pros and Cons of EBITDA

Recommended: Net Operating Income vs. EBITDA

Pros and Cons of Net Income

The Takeaway

When comparing EBITDA vs. net income, it helps to understand that these are two different measures of a company’s profitability.

Net income refers to the amount a business makes after all costs. EBITDA adds certain costs (namely, interest paid on debt, taxes, and amortization/depreciation expenses) back to net income to provide better insight into a company’s operational efficiency and profit-making potential.

If you’re in the market for a small business loan, a lender may look at either or both of these earnings metrics to see whether you have enough positive cash flow to comfortably make payments on the debt.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

Are EBITDA and net income the same things?

No. While both measure a company’s earnings, net income accounts for all costs, while EBITDA (earnings before interest, taxes, depreciation, and amortization) doesn’t account for interest paid on debt, taxes paid, and the non-cash expenses depreciation and amortization.

Can net income be higher than EBITDA?

It’s possible, but it’s not common. Since EBITDA (earnings before interest, taxes, depreciation, and amortization) adds certain expenses back to net income, it will almost always be higher. However, net income could exceed EBITDA in rare situations, such as when a company has significant non-operating income (like gains from asset sales) or tax credits that outweigh operating costs.

How is EBITDA converted to net income?

To convert EBITDA (earnings before interest, taxes, depreciation, and amortization) to net income, you would add interest, taxes, depreciation, and amortization to EBITDA.

Photo credit: iStock/Anna Frank

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

SOSMB-Q424-091

Many business owners use financing at some point, whether it’s to help them launch their companies or to fund expansion further down the line. No matter what stage your business is at, however, applying for your first business loan can feel overwhelming and intimidating.

While there’s no one-size-fits-all solution to getting a first-time business loan, this guide will break down what kinds of funding you may want to consider, where to find a first-time business loan, and what you can expect during the loan application process.

How Do You Apply for a First-Time Business Loan?

There are many different kinds of small business loans, and the application process can vary somewhat for each one. However, here are some basic steps that can help you find and apply for a first-time small business loan.

Check Your Credit Score

Your credit score is one of several factors that lenders consider when assessing how risky you are as a potential borrower. From the lender’s perspective, a borrower with poor credit has a higher risk of defaulting on loan repayments.

For a first-time business loan application, a lender may look at your personal rather than your business credit score (which you may not have established yet). Ranges vary depending on the credit scoring model, but generally fall between 300 and 850. A credit score of 700 or above is usually considered good, while a score over 800 is considered excellent. Credit scores are calculated from your payment history, credit usage, length of credit history, and recent credit history (such as applying for new accounts).

If you need a business loan for the first time and your business lacks credit history, there are some things you can do to establish a business credit score. Getting a business credit card and maintaining a successful record of paying it off each month is one strategy that can help you build credit over time.

Recommended: What Factors Affect Credit Score?

Figure Out How Much Money to Apply For

When you’re applying for a first-time business loan, it can be helpful to identify how much money you need to start your business and what the funds will be used for. Being able to provide justification for the amount you are requesting can improve your chances for loan approval.

For example, obtaining price quotes for new equipment or providing comparable listings for a real estate purchase can demonstrate your preparedness as a first-time business owner and/or borrower, as well as justify your need.

Debt-Service Coverage Ratio (DSCR) and How to Calculate It

The debt-service coverage ratio (DSCR) is a measure of the cash flow available to pay current debt obligations. Knowing what yours is can help you assess how much debt you want to take on. Lenders may also weigh your business’s DSCR as they make their decisions about offering financing.

DSCR is calculated by dividing the sum of a business’s earnings (before interest, taxes, depreciation, and amortization) by its current and proposed debt obligations. Even if this is your first time getting a loan, you may have short-term debt to factor in, such as rental agreements or outstanding credit card payments.

Borrowers may need a minimum DSCR to receive a loan. The threshold can vary by lender, requested amount, and current economic conditions. Generally, however, a DSCR below 1 indicates that a business might not be able to cover its debt payments in full. Therefore, applicants may need a DSCR above 1 to qualify for a first-time business loan.

Recommended: EBITDA Fully Explained

Gather Documentation

The paperwork you need to submit for a first-time business loan will depend on the type of loan, lender, and amount requested. In many cases, however, you need to provide:

•  Business licenses and registration

•  Commercial lease agreement

•  Business plan

•  Up to one year of business bank statements

•  Personal and business tax returns from the most recent three years

•  Business financial statements

•  List of current accounts receivable

•  Schedule of business debts

•  Proof of collateral

Types of First-Time Business Loans

Different types of business loans have different requirements, repayment terms, interest rates, and conditions. Here’s an overview of some leading options for first-time small business loans.

Bank Loans

Regardless of the age of your business, seeking a loan from a bank or credit union you already have an account with can be a logical place to start. Bank loans can come in various forms, including term loans and business lines of credit.

Business term loans give businesses a lump sum that is repaid (plus interest) over a designated period of time (known as the term). Generally, repayment is on a monthly basis. Term lengths can range from several months to multiple years.

A business line of credit provides access to a set credit limit. You can draw what you need when you need it and only pay interest on the amount you borrow. As you repay what you borrow, the funds become available to borrow again.

Both options can offer businesses some flexibility as to how they spend their financing. This may be advantageous for businesses with a wide range of operational and/or startup needs.

Banks often offer the best interest rates on business loans. However, they generally have strict qualification requirements, such as at least two years of business history, excellent credit, and a minimum amount of annual business revenue.

SBA Loans

SBA loans are business loans that are partially guaranteed by the U.S. Small Business Administration and issued by participating lenders, which can be banks or online lenders. Because the government will cover a large portion of the loan in the event of default, SBA loans represent less risk to lenders. As a result, you may have better luck qualifying for an SBA loan than a traditional bank loan.

SBA loans break out into four categories:

•  7(a) loans: The most common SBA loan, 7(a) loans can be an ideal option for business financing due to their long repayment terms and low interest rates. Plus, 7(a) loans can be used for a variety of purposes, including working capital, business expansions, or purchasing equipment and supplies. The maximum loan amount is $5 million.

•  504 loans: These SBA loans offer affordable financing for large equipment or real estate-related purchases. Terms can be as long as 25 years, with maximum loan amounts up to $5.5 million.

•  Microloans: These small loans (up to $50,000) are targeted specifically to startups. The SBA microloan program is fully funded by the SBA and administered by an intermediary network of nonprofit community-based lenders, rather than traditional banks.

•  Disaster loans: These low-interest loans provide up to $2 million to assist small businesses that have been negatively impacted by a declared disaster.

Getting an SBA loan is typically a time- and work-intensive process. However, it can be worth the effort due to their high loan amounts and favorable interest rates and terms.

Recommended: Conventional Business Loans vs SBA Loans

Business Acquisition Loans

Not every first-time business owner is starting from scratch. Purchasing an existing business may eliminate startup costs and allow for quicker cash flow.

A business acquisition loan is a tool for doing just that. Potential lenders will likely consider the existing business’s financial performance, as well as the applicant’s finances and proposed plan for the business under new ownership.

Invoice Financing

If your business is already serving customers, invoice financing can be a way to get a cash advance to tackle pressing needs. With this type of financing, you use your outstanding customer invoices as collateral for a loan. Typically, the lender will advance a large percentage of your unpaid invoice amount — potentially as much as 90%. When your customer pays the invoice, you receive the remaining percentage, minus the company’s fees.

You’re still responsible for collecting payment from your customers unless you choose invoice factoring, a form of invoice financing in which the invoices are sold outright to a factoring company.

Because your invoices serve as collateral, invoice financing can be easier to qualify for than other small business loans. However, borrowing costs tend to be higher than other financing options.

Equipment Financing

Purchasing equipment can be a significant cost for starting, maintaining, or expanding a business. Equipment financing is a type of loan that lets business owners make these essential, but costly, purchases without depleting their savings. You can use an equipment loan for anything from office furniture to medical equipment to farm machinery. Typically the equipment itself serves as collateral for the loan.

Equipment loans are provided by banks, SBA lenders, and equipment finance companies that focus solely on this type of small business loan. Depending on what you want to purchase and your company’s qualifications, you may be able to get an equipment loan that covers up to 100% of the value of the equipment you’re looking to purchase. You repay the loan over time, with interest.

Preparing Your Business for Loan Approval

The type of small business loan you choose may affect how you prepare your business for loan approval. However, there are some general guidelines you can follow, including:

•  Creating a detailed business plan that outlines your objectives, financial projections, and growth strategy.

•  Reviewing your personal and business credit scores, addressing any inaccuracies or issues.

•  Organizing essential documents, including financial statements, tax returns, and proof of collateral, if applicable.

•  Demonstrating stable cash flow and a clear plan for repaying the loan.

•  Researching lenders and loan options to find one that aligns with your needs, and build a professional relationship with potential lenders to strengthen your application.

Common Challenges for First-Time Borrowers

First-time business loan borrowers often face several challenges, including:

1.   Limited credit history: Many new business owners lack an established credit profile, making lenders hesitant to approve loans due to higher perceived risk.

2.   Insufficient documentation: Incomplete or disorganized financial statements, business plans, or tax records can lead to delays or rejection.

3.   Low cash flow: Lenders often look for consistent cash flow to ensure repayment ability, which startups may not yet demonstrate.

4.   High collateral requirements: Some lenders require collateral that first-time borrowers may not possess.

5.   Understanding loan products: Navigating the variety of loan options can be confusing, leading to unsuitable choices.

Proper preparation and financial guidance can help overcome these obstacles.

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Alternatives to First-Time Small Business Loans

If your business is still a startup, you may face difficulties obtaining traditional funding. But there are still more options you could consider.

•  Personal loans for business: These are traditional loans that you may be able to get as an individual. Not all lenders will allow you to use a personal loan for business use, so it’s important to check before you apply. And note that while paying your installments promptly for a personal loan may help your personal credit, it won’t help your business establish an independent credit history.

•  Crowdfunding: With crowdfunding, you set a monetary goal and create a marketing campaign to solicit funds online through a crowdfunding site. With rewards-based crowdfunding, people contribute to your project or business and get a gift or reward in return. Crowdfunding can help raise excitement about your business and test the waters to see how interested people are in your idea. However, it can take a fair amount of time and effort to run a successful crowdfunding campaign.

•  Loans from family and friends: Supportive friends and family members may be willing to loan you small amounts of money to help you get your business up and running. If you go this route, it can be a good idea to write up a promissory note so the amount of the loan and terms of repayment are clear, and there are no misunderstandings that could jeopardize your relationship.

The Takeaway

Applying for a first-time business loan requires preparation, clarity, and research. By developing a strong business plan, understanding your creditworthiness, and gathering necessary documents, you can increase your chances of approval.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

How does someone get a loan for the first time?

Requirements vary by lender and type of business loan, but you generally need to have a good-to-excellent personal credit score, strong business financials (or at minimum, a solid business plan), and proof of collateral to qualify for a first-time business loan.

How much can you borrow to start a business?

The amount you can borrow to start a business will depend on numerous factors, including your personal credit, your revenue history, the type of business it is, and the lender. Startup loans can range from $1,000 to $5 million. In some cases, you may have to use financing from multiple sources to get the funds you need.

What is a first-time business loan?

A first-time business loan is the first loan a business takes out, whether it’s a startup or an already established business. A first-time business loan can be virtually any type of business loan, including a Small Business Administration (SBA) loan, term loan, business line of credit, equipment loan, or business acquisition loan.

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website .

SOSMB-Q424-002

Understanding working capital requirements (WCR) is essential for maintaining a business’s financial health and operational efficiency. WCR refers to the amount of funding a company needs to cover its short-term liabilities and sustain day-to-day operations. It ensures a business can manage cash flow effectively, handle unexpected expenses, and capitalize on growth opportunities.

Keep reading to learn more on working capital requirements and how they can ensure your business is operating as it should.

What Is Working Capital Requirement?

Working capital is what’s left in current assets after you pay your current liabilities, like vendor invoices, taxes, and loan payments. The mathematical formula for working capital is simply current assets minus current liabilities.

Your working capital requirements (WCRs) refer to the amount of capital you need to cover those liabilities, or expenses. This requirement can change from month to month or quarter to quarter.

💡 Recommended: Net Working Capital

Why Does Working Capital Matter?

Working capital is crucial because it represents a company’s ability to cover its short-term liabilities with its short-term assets, ensuring smooth daily operations. Adequate working capital helps maintain liquidity, manage unexpected expenses, and support business growth without relying heavily on external funding.

In a perfect world, your clients would pay their invoices on time, giving you ample opportunity to then turn around and manage your own accounts payable. But as we know, that’s not always what happens. Sometimes clients pay late or their payment terms don’t align with the payment terms you have with your own vendors. Then you’re left with a gap between revenues coming in and money needing to go out.

Another situation where it’s important to understand working capital requirement (also called net working capital requirement) is if you spend a sizable amount on inventory, but then it takes a while to actually sell all of it. You’ve made a big expenditure without a guarantee of when you’ll make your return on investment, and yet you still have bills due.

When there’s a gap between assets and liabilities, it’s important to be able to plan for it before it happens. Planning ahead can help you strategize how to cover the gap, such as by applying for business loans to access the working capital you need in the short term.

💡 Recommended: How to Budget a Small Business

Working Capital Requirement Formula

Working capital is the difference between a company’s current assets and current liabilities, indicating its liquidity and ability to cover short-term obligations. Working capital requirement (WCR), on the other hand, is the specific amount needed to fund a company’s day-to-day operations and maintain smooth business functionality.

Let’s look at how to calculate working capital requirement so you can predict ahead of time how much working capital you’ll need to have on hand at any given time.

How to Calculate Working Capital Requirement

To calculate working capital requirement, you use the same formula as you would to calculate working capital:

Working Capital = Current Assets – Current Liabilities

Keep in mind that current assets aren’t always cash or liquid. They can also include inventory and accounts receivable. If you’re looking to ensure you have enough cash on hand to cover current liabilities, realize that you might want to consider taking out a working capital loan if you don’t have sufficient liquid assets to cover debts.

As an example, let’s say that you have $45,000 in current assets, including cash, inventory, and accounts receivable. You also have upcoming expenses of $50,000, including a tax bill, vendor invoices, and rent for your office space.

45,000 – 50,000 = – 5,000

In this example, you would have a deficit of $5,000 in working capital for this period. What can you do to make up for the gap? You could light a fire under a client to get them to pay their bill, take out a loan, or ask your vendor to extend payment terms.

Here’s another example. Let’s say you have the same $45,000 in assets but your expenses for this period are only $30,000.

45,000 – 30,000 = 15,000

Now you have a surplus of $15,000. You can set that money aside for a future project or investment. If your WCR fluctuates, it might be a good idea to not spend it unnecessarily, knowing you’ll need it to cover future working capital requirements.

Recommended: All About Getting a First-Time Business Loan

Working Capital Ratio

Another useful calculation is your company’s working capital ratio. Here’s how you calculate it:

Working Capital Ratio = Current Assets / Liabilities

This ratio indicates how much liquidity your company has. A ratio over two is considered highly liquid, while under one may indicate issues.

If your assets are $45,000 and your expenses $50,000, for example, your ratio would be 0.9 (45,000/50,000). If your assets are $45,000 and your expenses $30,000, your ratio would be 1.5 (45,000/30,000).

What Working Capital Requirement Indicates

Knowing how much working capital you need to cover expenses can help you plan ahead, and watching for changes in WCR can reveal important information about how your business is spending money and generating revenues over time. Being aware of these changes can help guide your financial strategy.

For example, if you see a sudden and sharp rise in your working capital requirement, the business is spending more on expenses and may not have extra capital to expand operations, acquire other businesses, or develop new products. If you plan to bring on investors, they may be concerned that you may not have enough working capital in the near future to cover your increasing expenses.

Look at why your WCR is rising. Is it a one-off because you’ve made a sizable investment in a project or made an unusually large inventory order? Or have your expenses risen over time without any real reason?

If your working capital requirements have risen over time, you have a few avenues to explore. One is to look at different business loan types that can provide the working capital you need to cover those gaps. Another is to reduce expenditures and thereby reduce your WCR. A third option is to raise prices or create a payment policy to get your clients to pay their invoices faster.

Recommended: Small Business Tax Tips

The Takeaway

Calculating your working capital requirement can help you make smarter financial decisions for your business. By looking down the road at expected revenues and expenditures, you can take steps to ensure you always have ample working capital for your business needs.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

What are the four key components of working capital?

Working capital takes these four components into consideration: cash, accounts receivable, inventory, and accounts payable.

What factors affect working capital requirement?

Factors that affect working capital requirement (WCR) are the money you have coming in (your assets) and your outstanding debts (your liabilities).

What are the requirements of working capital forecasting?

Forecasting working capital requirements necessitates looking at trends in your revenues and expenses, as well as foreseeing any unusual changes in either of those.

Photo credit: iStock/Nikcoa

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

SOSMB-Q424-094

Both equity and debt financing can give you the funding you need to grow your business, but they work in very different ways. With equity financing, you sell shares of your company to investors to raise capital. If you use debt financing, you borrow money from a bank or other lender and pay it back over time with interest. Which option makes the most sense for your business will depend on several factors, including the stage your business is at and how much capital you need.

Keep reading to learn more about how equity and debt financing work, the pros and cons of each, and how to choose the right source of funding for your venture.

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What Is Equity Financing?

Equity financing (also called equity funding) is when an individual or company invests in a business in exchange for a percent of ownership of that company. The funds don’t have to be repaid, but the investor, who now has equity in the company, may have voting rights or other influence on how the business is run. They are also entitled to a share of the company’s profits.

To raise capital through equity financing, you need to find investors who are interested in your business, which involves pitching your business. If an investor decides to fund you, they would give you an agreed upon amount of money for a certain amount of ownership, or stake, in your company. The amount you can raise and the percentage of ownership that you give will depend on the investor and how much your company is worth. Investors are essentially paying for a percentage of your company’s future profits.

Recommended: Guide to Seed Funding for Startups

Benefits of Equity Financing

Here’s a look at some of the advantages of equity financing.

It Opens the Door to the Capital You Need

If your company is new or just getting off the ground, you may have difficulty finding a small business loan for startups. But equity financing was designed with startups in mind. Investors also tend to provide more funds than a bank might loan you, which means that equity financing may give you all the funding you need to launch or grow your business.

It Gets You Access to Industry Experts

Investors tend to invest in industries they know well. That’s a potential boon for you because your investors may be able to provide operational expertise you lack and make introductions to potential partners or customers in your field.

The Funds Don’t Have to Be Paid Back

With equity financing, you don’t have to pay back the funds you receive or pay interest on those funds. You will, however, be required to share future profits with investors.

💡 Recommended: What Is Debt Financing

Drawbacks to Equity Financing

Though equity financing could be the solution to getting the capital you need, there are a few potential downsides to consider.

You Lose Some Ownership (and Profit)

With debt financing, you retain full ownership of your startup, and once you pay back your loan, you can keep all the profit your company makes. But when you take on investors, you share that profit, which may mean less money in your own pocket down the line.

You’re Not the Only Decision Maker

While having investors who have experience and contacts in your industry can be a good thing, it does add more voices and opinions to the mix. Instead of you (and maybe a cofounder) calling all the shots, you may now need to take your investors’ opinions into consideration.

Funding Can Be Slow

Acquiring equity financing is often a long, drawn out process. You typically need to organize all of your financial information, create an impressive deck, and make a compelling pitch to multiple parties to find the right investor. Then, if you do get a bite, you’ll have to negotiate terms.

Recommended: Tips for Starting a Small Business

Examples of Equity Financing

There are several types of equity financing you can consider for your small business.

Shares

There are actually two ways you can use shares to raise capital for your company. You can sell shares to private investors, who then hold a percentage of your business’s equity. Or you can make shares available to the public through an Initial Public Offering (IPO), which involves selling stock on a public stock exchange.

Venture Capital

A venture capital (VC) firm or individual may invest money in a company with the intent of helping it grow to profitability with the VC’s resources and expertise. The investor typically exits the company after a period of several years by initiating a merger, acquisition, or IPO.

Angel Investment

An angel investor is typically a high-net-worth individual who invests money in a business with high growth potential, typically in exchange for ownership in the company. Unlike a venture capitalist, an angel investor uses their own money to invest in the business. Many angel investors look to invest in early-stage startups.

Convertible Debt

Another example of equity financing is convertible debt. With this type of hybrid financing, a lender or investor gives a startup a loan. If the business meets certain performance goals, they will then convert the unpaid balance of that loan into an equity stake in the company. If those benchmarks aren’t made, the startup must repay the loan.

💡 Recommended: Working Capital Assessment

What Is Debt Financing?

Debt financing involves taking out a loan or line of credit from a bank or other lender that your business must pay back, along with interest. With a traditional term loan, the business receives a lump sum of money up front then repays the loan in regular monthly installments (that include both principal and interest) over the term of the loan.

Benefits of Debt Financing

Debt financing comes with several advantages. Here are some to consider.

You Retain Full Ownership (and Profit)

Unlike equity financing, taking out a small business loan still allows you to retain full ownership of your business and full access to the profits it generates. That means you don’t need to consult with lenders when making decisions about your business. Once you repay the loan, your relationship with the lender ends.

There May Be Tax Advantages

The interest you pay on debt financing is typically a tax-deductible business expense, which means it can lower your tax bill at the end of the year.

Recommended: 22 Small Business Tax Deductions

It’s Fast

Getting debt financing is typically a faster process than getting equity financing, which involves identifying and pitching to investors, then drawing up documents outlining the equity agreement. If you choose a small business loan from an online lender, you can often get funded in a matter of days.

Drawbacks of Debt Financing

Debt financing also has some drawbacks that you’ll want to keep in mind.

You Have to Repay the Money

With a loan, you have to pay the money back in full, plus interest, and often according to a set schedule, no matter how well your business is doing. Should you experience a dip in cash flow and miss a payment, you can get hit with a hefty fee.

It May Be Challenging to Qualify

If your business is new or just getting off the ground, it can be difficult to qualify for a traditional bank loan. These loans often require at least two years of business history, excellent credit, and a minimum amount of annual revenue. Online lenders generally have more flexible criteria, but generally charge higher interest rates and offer lower loan amounts.

You May Put Your Assets at Risk

Many types of debt financing require collateral, which might be real estate or equipment. If you aren’t able to repay your loan, the lender has the right to seize that asset, which could jeopardize your ability to run your business.

Examples of Debt Financing

There are many different types of business loans. Here are some options you may want to explore.

Bank Loans

These are often the most difficult kind of funding for small businesses to qualify for. Bank loans tend to approve applicants who have a credit score of 650 or higher and who have been in business at least two years. However, these loans typically come with some of the most attractive rates and terms.

SBA Loans

SBA loans are business loans partially guaranteed by the U.S. Small Business Administration and issued by participating lenders. Because these loans represent less risk to the lender, they can be easier to qualify for than regular bank loans and offer flexible terms, large loan amounts, and low interest rates.

Line of Credit

A business line of credit is a flexible form of financing that allows you to borrow money as you need up to an approved limit. You only pay interest on what you actually borrow and, as you pay the money back, it’s available to borrow again.

Merchant Cash Advance

If you need cash quickly and your business involves credit or debit card sales, you might consider a merchant cash advance (MCA). With an MCA, a financing company gives you a lump sum of cash up front that you repay using a percentage of your debit and credit card sales, plus a fee. These are short-term loans with high interest rates and fees. But on the plus side, the qualifications are minimal, and you can see funds in your account as soon as the next business day.

Invoice Factoring

If your business sends invoices to clients to get paid, you may qualify for invoice factoring. With this financing solution, you sell your outstanding invoices to a factoring company in exchange for a percentage of the value of those invoices. Once the invoices have been paid to the company, you receive the rest of the value, minus the factoring company’s fee.

The Takeaway

When you’re debating debt financing versus equity financing, it often comes down to the nature of your business and its stage of development. If you’re looking for working capital as well as guidance and connections, equity financing could be the perfect solution that can take your business to the next level.

If you don’t like the idea of giving up ownership of your company — or having more cooks in the kitchen — and can qualify for financing, you may be better served by a small business loan.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

What is the main difference between debt financing and equity financing?

Debt financing involves borrowing money that must be repaid with interest, typically through loans or bonds. Equity financing, on the other hand, involves raising capital by selling ownership stakes in the company, such as shares, to investors.

What are the advantages of equity financing over debt financing?

Equity financing does not require repayment or interest, reducing financial strain, and provides access to investor expertise and networks. However, it involves giving up partial ownership and control. Debt financing, while maintaining full ownership, creates fixed repayment obligations.

How should a business decide between debt and equity financing?

The decision depends on factors like financial stability, growth stage, and control preferences. Startups often prefer equity to avoid immediate repayment, while established businesses may choose debt to retain ownership and leverage predictable cash flows to meet obligations.

Photo credit: iStock/skynesher

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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Debt factoring describes a situation when a business works with a third party company to receive payment on unpaid invoices. The debt factoring company usually buys the invoice at a discount and provides the remaining amount once it is able to collect payment.

As you may expect, there are fees involved, but if you’re having working capital issues, debt factoring may be a viable solution.

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What Is Debt Factoring?

Debt factoring, also called invoice factoring, is when a company sells its unpaid invoices from its accounts receivables to another company at a discount. The remaining amount is paid once the third party company is able to collect payment, minus any fees it charges.

Companies that make use of debt factoring often do it to shore up working capital issues. With debt factoring, they may be able to cover all of their operational expenses and make payments on their short term debts.

Keep in mind that traditional small business loans may be a better fit, especially when it comes to working capital.

Recommended: 15 Types of Small Business Loans

How Debt Factoring Can Help Small Businesses Manage Cash Flow

Debt factoring is best utilized as a boost to working capital. Companies that are having liquidity issues because of cash stalled out in accounts receivable can use debt factoring to help pay for any of its operating expenses and short term debts. While there are fees involved with debt factoring, the benefit of it is that the money obtained from it can be used to fund incoming orders and jobs. In other words, it can help keep business moving.

Business owners strongly considering debt factoring should take the time to compare companies and fees. Each business charges differently for its services, so it is possible to save money by working with a different company.

Improving Financial Stability With Debt Factoring

One of the strongest arguments that can be made in favor of debt factoring is that businesses are not taking on additional debt to rectify cash flow issues.

Businesses having issues with working capital may not want to endanger its credit score and assets with a business loan if there’s a possibility it won’t be able to make the monthly payments. By working with a debt factoring company, they are keeping their finances relatively the same. For many small businesses, including new ones, this may be enough of a reason to work with a debt factoring company.

On the flip side of this argument, just remember that you are losing a small percentage of the invoice to the debt factoring company through fees. While debt factoring can certainly help with working capital, you are reducing your overall profit each time you do it.

Recommended: Small Business Startup Loans

Debt Factoring vs Small Business Loans

One of the biggest cons to debt factoring is that it reduces a company’s profit because of the fees charged by the third party. Companies vary on what they charge, but a common fee is to charge a small percentage of the invoice amount for each week they are unable to receive payment.

Depending on how ethical of a company they are, this may disincentivize them to pursue payment from your customers right away. Plus, many debt factoring companies charge other fees, such as ACH transfer fees or account management fees.

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The next thing you want to consider is customer perception. While some of your customers may not make their payments in a punctual manner, how will they feel knowing their account was essentially sent to a collection agency? Will this hurt your relationship with them? Many debt factoring companies are 100% professional and ethical, but some may not transmit that image.

Before deciding which company to work with, make sure you read plenty of customer reviews.

Another thing to consider is that debt factoring isn’t ideal for every company. Many businesses simply don’t revolve around invoices. For these companies, a small business loan may be the best option.

If you are considering debt factoring to solve your working capital issues, a small business loan may be a better fit. Benefits of small business loans include:

•  You may save money in fees

•  You may be able to borrow a larger sum of money

•  It won’t affect your company’s image

•  You will still be in control of the invoice

•  You won’t lose money in profits

Recommended: What Is the Minimum Credit Score for a Business Loan?

The Takeaway

Debt factoring allows a company to sell its unpaid invoices to a third party company at a discount. That company is then responsible for collecting payment. Once payment is received, any remaining invoice amount is forwarded to the business minus any fees.

While there are certainly benefits to debt factoring, it may make more financial sense to pursue a small business loan. Not only may you be able to borrow a larger amount, but you might also save money in fees.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

What is the difference between debt factoring and invoice financing?

With debt factoring, you sell the invoice to a third party company at a discount and it takes control over collecting payment from the customer. Debt factoring companies typically charge a weekly fee for each week the invoice is unpaid. While responsibility falls on the debt factoring company, it’s the small business that is penalized.

Invoice financing, on the other hand, uses unpaid invoices as collateral. You are still responsible for collecting payment from the customer. Once your customer pays, you use the money to pay off the loan. Some business owners may prefer it over debt factoring because they keep total control over their company’s image.

What are the disadvantages of debt factoring?

The biggest drawback of debt factoring are the fees, which can eat into your company’s profit. Also, because you are no longer in control of securing payment, your company’s image may be sullied by the third party company. If you need the invoice for working capital, a short term small business loan may make more financial sense. You may pay less in fees and may be able to borrow a larger amount.

What is an example of debt factoring?

A company installed carpet for a 4,000 square foot office building, but has yet to receive payment on the $28,000 invoice. Because the project used up so much inventory, they are now having working capital issues. To rectify this so they can continue operations, they decide to utilize debt factoring.

The debt factoring company gives them 80% of the invoice amount, which equals $22,400. However, they charge 5% for each week they are unable to receive payment. It takes two weeks for the customer to pay, which means the factoring company keeps $2,800 of the $28,000 invoice.

Photo credit: iStock/PeopleImages

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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