Thinking Debt in Business Finance

INTRODUCTION

To obtain funding for its projects, a company may consider two major options: equity financing and debt financing. Business finance is the act of securing economic support to supply funds for your business expenses. Anyone who knows anything about business will tell you that to make money you have to spend money, and businesses often require assistance to secure funding for growth and development (Xia et al, 2022).

business finance, the raising and managing of funds by business organizations. Planning, analysis, and control operations are responsibilities of the financial manager, who is usually close to the top of the organizational structure of a firm. In very large firms, major financial decisions are often made by a finance committee. In small firms, the owner-manager usually conducts the financial operations. Much of the day-to-day work of business finance is conducted by lower-level staff; their work includes handling cash receipts and disbursements, borrowing from commercial banks on a regular and continuing basis, and formulating cash budgets.

Financial decisions affect both the profitability and the risk of a firm’s operations. An increase in cash holdings, for instance, reduces risk; but, because cash is not an earning asset, converting other types of assets to cash reduces the firm’s profitability. Similarly, the use of additional debt can raise the profitability of a firm (because it is expanding its business with borrowed money), but more debt means more risk. Striking a balance—between risk and profitability—that will maintain the long-term value of a firm’s securities is the task of finance.

WHAT IS EQUITY FINANCING?

Equity financing involves raising capital through the shares of a company. In exchange for a stake in ownership, an investor gives his money to a company and becomes a shareholder in the company (Zhang et al, 2019).

An important feature of equity financing is that the investment sum is not paid back. If the company becomes bankrupt, there is no liability for the repayment of the investment sum; essentially, the investor’s money goes down with the company. Also, because the company needs not try to pay back the investment sum or make monthly instalments, it has more cash on hand for operating expenses (Xia et al, 2022; Wang & Zhu, 2013)

Raising capital by equity, however, implies a readiness to part with a chunk of the ownership of the company. The investor takes as much of the ownership of the company as the agreement states and the result is a loss of control and dilution of shares unless a deal is constructed to buy back the investor’s stake (Hamzah et al, 2018).

WHAT IS DEBT FINANCING?

Debt financing, on the other hand, occurs when companies borrow money to be repaid at a later date, usually with interest. The loan obtained may be collateralized with assets or it may be unsecured in which case the line of credit is usually less. This mode of financing is typically time-bound, that is, the sum borrowed with interest must be paid back at an agreed date. Debt is a viable option when there is a high return against a low interest. While bank loan is the most common form of debt financing, there are also other forms such as bonds and debentures (Xia et al, 2022).

In contrast to equity, debt does not dilute the ownership and control of the company. Its ownership remains while the company also has more funds at its disposal to run its affairs (Zhang et al, 2019).

In addition, the relationship with the lender is terminated once the loan is repaid, putting the company in a more positive light and increasing its value (Mun & Jang, 2017).

A major challenge in debt financing is that many lending institutions demand to be convinced about the company’s qualification for the loan and the ability for repayment, thus it may be difficult to receive debt financing, especially for small companies (Hui et al, 2018).

Debt financing also comes with a structured payment arrangement. This means that as and when due, the company must make repayments. Invariably, it puts pressure on the company to always have the capital inflow to meet all business expenses, while at the same time servicing the loan incurred (Hamzah et al, 2018).

Needless to say, debt may be risky to the existence of the company. It has a fixed cost but represents a major potential threat. In the event of an inability by the company to service debts, the lenders may foreclose, leading to liquidity in assets and the end of its operation (Wang & Zhu, 2013).

Equity appears less hostile to the future of a company. Admittedly, it leads to dilution in ownership, but it also hardly possesses the life-threatening consequences of incurring too much debts. Business owners may be quick to jump at the opportunity to improve cash flow without the risks associated with debt financing (Mun & Jang, 2017).

But debt financing is financial leverage. As a company keeps growing, debt may be a less expensive option for funding its activities. In this case, the borrowing cost of the debt would be less than the growth rate of the business’ equity (Rashid, 2014).

TYPES OF EQUITY FINANCE

• Venture Capital: High growth potential businesses with scalability have often taken this path as venture capitalists are highly devoted to the prosperity of your company. Audits are quite common as precautionary measures since venture capitalists aim to invest large amounts with the prospect of seeing a large return.
• Crowdfunding: Over the last 10 years or so, crowdfunding has seen a huge rise in popularity. They don’t require any auditing or vetting of the company, but the effectiveness of these crowdfunding campaigns are heavily reliant on how successful the promotional campaign is. There is a higher risk of not raising the funds you desire and that’s where the trade-off lies.
• Angel Investors: Similar in nature to venture capitalists but unique in the way that they generally invest in the early stages of a business’ lifespan. Angel investors are individuals with an incredibly high net-worth taking large risks on start-ups, so they are hard to come by.

TYPES OF DEBT FINANCE

There are a variety of funding options to choose from when financing your business with debt. Here are some of the most common types of debt financing.

Business term loans

Business term loans are one of the standard types of debt financing and operate similarly to a car loan or mortgage. With a term loan, you borrow a lump sum of capital upfront for a specific purpose. You repay the loan, with interest, over a set period of time with fixed, equal payments.

Term loans are well-suited for distinct use cases, such as business renovations or expansions. Some loans, like equipment financing or commercial real estate loans, are designed to facilitate specific business purchases.

SBA loans

SBA loans are small-business loans issued by participating lenders, typically banks and credit unions, and partially guaranteed by the U.S. Small Business Administration. The partial government guarantee reduces the risk for lenders and incentivizes them to work with small businesses.

There are several types of SBA loans, but in general, these loans are structured as term loans. The SBA sets guidelines for lenders regarding maximum loan amounts, repayment terms and interest rates.

SBA loans can be a good option for a variety of purposes, including working capital needs, business expansions and equipment purchases.

Business lines of credit

A business line of credit gives you access to a set amount of funds that you can draw from as needed. You only pay interest on the funds you draw, and in most cases, once you’ve paid back what you’ve borrowed, the credit line resets to the original limit.

Business lines of credit are one of the most flexible forms of debt financing — making them suitable for managing cash flow gaps and covering operating expenses, such as purchasing inventory or paying employees.

Business credit cards

Business credit cards operate similarly to business lines of credit. With a business credit card, you have access to a set amount of funds that you can pull from to make purchases. You’ll only start accruing interest on your balance, however, if you don’t pay your bill in full every month.

Business credit cards are a good way to finance every day or short-term expenses — especially since most cards offer rewards programs. These programs give you the ability to collect cash back, travel miles or bonus points for spending on your card.

Invoice financing and invoice factoring

Invoice financing and invoice factoring both allow you to access capital using your unpaid invoices. Invoice financing involves borrowing money from a lender (in the form of a loan or line of credit) against your outstanding invoices, whereas invoice factoring refers to selling your invoices to a factoring company at a discount.

Although these two types of debt financing have their differences, both are well-suited for business-to-business companies that have cash flow issues due to unpaid customer invoices.

Merchant cash advance

With a merchant cash advance, or MCA, a company gives you a lump sum of capital upfront that you repay using a percentage of your debit and credit card sales, plus a fee. The MCA company typically deducts a daily or weekly percentage of your sales until the advance is repaid in full.

Although MCAs can be used to cover cash flow gaps and short-term expenses, they are one the most expensive forms of debt financing — with annual percentage rates that can reach as high as 350%. You should consider all other financing options before turning to a merchant cash advance.

WHY FINANCE WITH DEBT?

Firstly, the company retains its profits. When debts are obtained, interest is ascertainable and both the principal sum and the interest may be paid off within a given period of time. A creditor is only entitled to the agreed sum and interest and is not entitled to more interest simply because the company makes more profit. He has no benefit in the future profit of the company (Hui et al, 2018).

This is a sharp contrast to equity financing where the company is under an obligation to share its profits with its investors. The more profit a company makes, the more benefit the investors are entitled to. Therefore, the company retains more rewards in debt than it would if it had sold stocks for financing its growth. Once the debt is repaid, the company ceases to be indebted to the lending individuals or institutions. On the other hand, shareholders remain a part of the company and share in the profit until their shares are bought over (Rashid, 2014).

Moreover, a company might actually consider taking debts for tax advantage. Tax authorities consider principal and interest payments on debts may be considered as business expenses, making it even more cost-effective as a form of financing for company projects.

Also, the cost of debt is cheaper. An equity investor will typically demand a higher return. The cost of equity is usually more expensive than the cost of debt since equity investors take on more risk than bondholders.

Finally, financing the company by equity means letting go of the control of your business. It also means complying with new shareholders’ expectations of the growth and affairs of the company. They enjoy the right to be involved in decisions affecting the company since they also have a stake. Undoubtedly, your control over the business is limited, and depending on how far you go, may become ousted. Taking on stocks may lead to the loss of grip of a businessman over his business. On the other hand, lenders do not try to exert control over the company as long as the debt is regularly serviced and the company remains in a position to keep doing so (Hui et al, 2018).

A CAVEAT, HOWEVER

While the cost of debt is generally lower than the cost of equity, taking on too much debts is a negative reflection on the assessment of the company. The more debts a business takes on, the higher its chances of default. This flags a risk signal to prospective investors and debt investors may accordingly demand a higher interest rate to compensate for the risk they are taking on (Sapienza et al, 2003).

Also, as the possibility of a potential default in debt arises, the valuation of the company’s stock plunges and as a result, shareholders’ returns are affected.

Although companies may consider using debt to enhance their growth for a high leverage, a leverage too high exposes the company to risks of default in payment and consequent liquidity (Ishikawa & Takahashi, 2010). As much as the company is willing to take advantage of a high leverage, it must generate sufficient operating cash to fulfil debt obligations, otherwise, the consequence for the business could be severe.

A company requires a balance of debt and equity to keep its average cost of capital at its minimum and maintain its liquidity (Dobbins, 1993).

HOW TO CHOOSE THE RIGHT FINANCE TYPE FOR YOUR BUSINESS

The values you hold dear and the vision you have for your company are all things you’ll need to consider when deciding how to finance your business. One way to do this is by asking yourself a few questions:

• What is the money for? Will it be used to improve or maintain a cash flow situation? Is it just to repay another debt? Looking at the reason for your funding will give you a good starting point on figuring out what type of financing is most suitable.
• How much do you need? Some types of business financing simply don’t offer larger sums of money. Answering this question can eliminate a lot of options and make the choice clearer.
• Will you need financial help in the long-term or short term? Certain business finance options will only provide one-time funding offerings for start-ups, others specialise in providing more continued, long-term agreements.
• Does the risk outweigh the reward? Lots of companies turn to financing as a means of betting on the success of a business plan, they just need the capital to get it off the ground. If the plan fails, they’ll either be left in debt and a failing enterprise or have given up a stake in the business with not much to show for it. Business finance by definition brings an inherent risk, so due diligence in analysing it is a must.

REFERENCES

Dobbins, R. (1993), “An Introduction to Financial Management”, Management Decision, Vol. 31 No. 2

Hamzah, S.R., Ishak, N. and Rasedee, A.F.N. (2018), “Risk shifting elimination and risk sharing exposure in equity-based financing – a theoretical exposition”, Managerial Finance, Vol. 44 No. 10, pp. 1210-1226.

Hui, X., Li, B. and Li, M. (2018), “Entrepreneurial management equity allocation and financing structure optimization of technology-based entrepreneurial firm”, Nankai Business Review International, Vol. 9 No. 3, pp. 395-412.

Ishikawa, M. and Takahashi, H. (2010), “Overconfident Managers and External Financing Choice”, Review of Behavioral Finance, Vol. 2 No. 1, pp. 37-58.

Mun, S.G. and Jang, S.(S). (2017), ““Understanding restaurant firms” debt-equity financing”, International Journal of Contemporary Hospitality Management, Vol. 29 No. 12, pp. 3006-3022.

Rashid, A. (2014), “Firm external financing decisions: explaining the role of risks”, Managerial Finance, Vol. 40 No. 1, pp. 97-116.

Sapienza, H.J., Korsgaard, M.A. and Forbes, D.P. (2003), “THE SELF-DETERMINATION MOTIVE AND ENTREPRENEURS’ CHOICE OF FINANCING”, Katz, J.A. and Shepherd, D.A. (Ed.) Cognitive Approaches to Entrepreneurship Research (Advances in Entrepreneurship, Firm Emergence and Growth, Vol. 6), Emerald Group Publishing Limited, Bingley, pp. 105-138.

Wang, Z. and Zhu, W. (2013), “Equity financing constraints and corporate capital structure: a model”, China Finance Review International, Vol. 3 No. 4, pp. 322-339.

Xia, X., Chen, W. and Liu, B. (2022), “Optimal production and financing strategies for capital-constrained closed-loop supply chain under risk aversion”, Kybernetes, Vol. ahead-of-print No. ahead-of-print.

Zhang, L., Zhang, S. and Guo, Y. (2019), “The effects of equity financing and debt financing on technological innovation: Evidence from developed countries”, Baltic Journal of Management, Vol. 14 No. 4, pp. 698-715.