Debt financing: what it costs a limited company, beyond the interest

Debt financing means raising money you pay back, with interest or fees, rather than selling a share of your company to get it. The interest is the part everyone compares, and it is rarely the part that decides anything. Borrow as a limited company and you will normally be asked for a personal guarantee, which puts your own money behind the company's debt. A secured lender will also register a charge over the company's assets, which limits what you can do next. None of that makes debt the wrong answer. It does mean the question is not 'what's the rate', but 'what am I signing, and can I already see where the repayments come from'.

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What debt financing is, and what counts as it

Anything you borrow and pay back counts: a term loan, an overdraft, invoice finance, asset finance, or a business credit card balance. What makes it debt rather than equity is that the lender gets interest and its money back, and never a share of your company.

Which facility suits you depends on what the money is for. Short-term gaps suit short-term facilities, like an overdraft or invoice finance. A defined purchase suits a term loan or asset finance. Match the length of the borrowing to the life of the thing you are buying and most of the rest follows. For what each one costs and how fast it arrives, see our guide to alternative business funding.

One option sits outside the commercial market. The Growth Guarantee Scheme on GOV.UK is government-backed lending of up to £2m per business group, delivered through accredited lenders. It covers term loans, overdrafts, asset finance, invoice finance, and asset-based lending, and it is open to UK businesses with turnover up to £45m. Whether a particular lender is accredited is worth asking, because not all are.

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Debt or equity: the one question that settles it

Most comparisons line the two up feature by feature: you repay a loan and you don't repay an investor, a lender takes interest and an investor takes shares. All of that is true, and none of it tells you which to choose.

The question that does is whether you can already see where the money comes back from.

A defined cost with a return you can date is a debt question. Stock for a season you have traded before, a machine that lets you take an order you have already been offered, the gap between delivering work and being paid for it: you know roughly what each earns and roughly when, so a fixed repayment is a schedule rather than a risk. Loan interest is also usually a deductible business expense, which quietly makes borrowing cheaper than the headline rate suggests. Ask your accountant how that applies to your company.

A bet that might not pay for years is an equity question. If you are pre-revenue, spending on research, building something before anyone will buy it, or taking market share at a deliberate loss, there is no repayment source yet. A fixed monthly repayment set against uncertain income is how a sound company fails. An investor shares that risk, because they are paid out of the upside if there is one, and that is what the ownership you give up actually buys. It is worth understanding what equity really costs you before you decide.

Two other things pull the same way. If what you need as much as the money is someone who has done this before, an investor brings that and a lender does not. And if you already have shareholders, read your shareholders' agreement first, because some require investor consent before the company borrows at all.

Plenty of companies use both at different times: equity for the long bet, borrowing for the defined cost. The mistake is using one where the other belongs.

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What you're actually signing

The paperwork is where debt stops being a number and becomes a commitment. Three parts of it matter more than the rate.

The personal guarantee. This is the one that surprises directors. A personal guarantee is a legally binding agreement that you will personally repay the debt if the company cannot. GOV.UK's guidance for directors sets out three shapes it can take: unsecured, resting on your own creditworthiness; secured, with a charge against your property; and joint and several, where several guarantors are each liable for the whole debt rather than a share of it. Lenders ask for one more often when a company is newly formed, has a short trading history or a poor credit record, or where the sum is large. There is more on what a personal guarantee commits you to in our guide.

We will ask you for one too. Every new iwoca Flexi-Loan needs a personal guarantee from at least one director, though not every director has to sign. We would rather you read that here than meet it in a facility letter. What is worth negotiating, with any lender, is the shape rather than the principle: a capped guarantee commits you to a number, and an uncapped one commits you to the debt.

The charge. If the facility is secured, the lender takes a charge over company assets. That charge has to reach Companies House within 21 days of being created, under section 859A of the Companies Act 2006. Missing the window is the lender's problem rather than yours, since an unregistered charge can be void against a liquidator, but it tells you how closely this paperwork is tracked.

The negative pledge. A secured facility usually carries one, and it is the clause nobody reads. It means you cannot grant security to another lender, sell substantial assets, or take on more debt without the first lender's consent. That is the real control cost of borrowing, and it is the part the usual framing leaves out: you keep every share and every vote, and you may still need permission to do the next thing.

Financial covenants work the same way. Breach one and the lender is entitled to demand the whole balance back immediately, which is why the ratio below is worth understanding before you agree to it rather than after.

If any of this is landing while the company is already under real strain, take advice from an insolvency practitioner rather than a lender. A director's duties change as a company approaches insolvency, and that is a legal question, not a funding one.

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How much debt is too much?

More than your trading can service with room to spare. The common test is the debt service coverage ratio: operating income divided by the payments due on your debt. Most lenders look for about 1.25, which means £1.25 of income for every £1 of debt service.

That 1.25 is a convention rather than a rule, and lenders set their own. It shows up in two places. Before you borrow, it is the sum that decides how much a lender will offer. After you borrow, it is often a covenant you have to keep, and that is the version that bites: a ratio that drifts below the line hands the lender the right to call the balance in.

So the useful question is not whether you can afford the repayment this month. It is whether you could still afford it after a month of slippage on your biggest customer, or through a quiet quarter. Run it as a cash flow forecast with the new repayment in it, and count every existing commitment: leases, asset finance held in a trading name, a merchant cash advance taking a slice of daily takings, and a director's loan the company is servicing. Those are the ones usually left out, and they are in the lender's version of the sum whether or not they are in yours.

Repayments also need predictable income, not just sufficient income. Regular money going out needs regular money coming in, which is why a company with lumpy revenue can fail a test that a smaller, steadier one passes.

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Where an iwoca Flexi-Loan fits

If the answer is debt and the need is a timing problem, that is the kind of gap an iwoca Flexi-Loan is built for: a VAT bill due before your customers pay, payroll landing ahead of a big invoice, or stock for a season you can already forecast. It is a business loan with flexible repayment options.

You choose a fixed term of between 12 months and five years, so you know the repayment schedule from the outset. Because there's no fee for repaying early, you can clear it as soon as the cash arrives – many of our customers only take out our finance for a few weeks, or even days.

Flexi-Loan in action: Dovetail and Slate A seasonal dip put pressure on cash flow at Dovetail and Slate, and founder Guy Walker needed funding to cover VAT, salaries, and supplier bills until revenue picked up. He bridged the gap without committing to funding for longer than he needed, repaying as cash flow recovered. Read Guy's story

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Debt financing FAQs

What is an example of debt financing?

A term loan is the clearest one: you borrow a set amount and repay it in instalments over an agreed period, with interest. An overdraft, invoice finance, asset finance, and a business credit card are all debt financing too. So is a loan from a director, if the company pays interest on it and repays the capital.

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What are the downsides of debt financing?

You have to repay it whether or not the business is profitable, so the repayment is a fixed cost in a month when your income is not. Beyond that, the downsides people miss are the personal guarantee, the charge over company assets, and the covenants that come with a secured facility. Those commit you personally and restrict the company in ways the interest rate never shows.

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Is debt cheaper than equity in the long run?

It depends on whether the company grows. The textbook answer is that debt is cheaper, because a lender's expected return is lower than an investor's and the interest is usually deductible. That holds if the business performs. If it does not, debt is the more expensive choice: you still owe the money, and the repayments carry on through the bad quarter that caused the problem.

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Is debt financing a good idea for a startup?

As a general rule, no. An early-stage or pre-revenue company would start with a repayment schedule at the point where it either has no revenue at all or highly unpredictable income, which is the hardest moment to meet one. Debt becomes practical once you have a defined customer base, regular sales, and revenue you can forecast.