Have you ever wished to finance your business without losing ownership in the firm?
Undoubtedly, the procedure is found to be cheaper than raising capital, owing to the considerations in tax payments.
When a company borrows money to be paid back on a future date along with interest, it is known as debt financing. Although the term “debt” tends to have negative implications, most companies find it absolutely necessary in order to improve their financial position in the long run.
Before formulating the importance of debt financing in the world of business, let’s first understand each and every terminology in detail.
What Do We Mean By Financing?
Financing refers to the act of providing funds to be used in business activities, making purchases, or investing. Financial institutions and banks are actively involved with financing as they provide capital to businesses, consumers and investors to help them achieve their goals.
Financing may be classified into two types: debt and equity. Debt must be paid back, but you’ll never lose ownership in the firm, and the amount to pay in interest is tax deductible which will reduce your net obligation. Equity does not need to be paid back, but it relinquishes ownership to the shareholder.
While both have their respective advantages and disadvantages, companies mostly prefer to use a combination of both operations in order to attain maximum benefits in the financial position.
What is Debt Financing?
When you borrow money from an external source and promise to return the principal in addition to an agreed-upon percentage of interest, you take on debt. It is the most common form of financing for new businesses.
Debt financing is a time-bound activity where the borrower needs to repay the loan along with interest at the end of the agreed period. The payments could be made half yearly, monthly or towards the end of the loan tenure. An important feature in debt financing is the fact that you are not losing ownership in the company.
Another important aspect is that the loan is secured or collateralized with the assets of the company taking the loan, and this is usually part of the secured loan. If the loan is unsecured, the line of credit is generally less.
Financial institutions such as banks, building societies and credit unions are the primary sources for debt financing, though debt can also be issued by a private company or even by a friend or family member.
Advantages of Debt Financing
As mentioned earlier, you retain every right to run your business however you choose to, without an external interference. You are only obligated to the financial institution to make the agreed-upon payments on time, and the business relationship ends once you’ve repaid the loan in full.
Deductions in Tax
In most cases, the principal and interest payments on a business loan are classified as business expenses, and hence, they get deducted from your business’s income at tax time. It helps, in this case, to think of the government as a business “partner”, with a 30% ownership stake (or whatever your business tax rate is).
Lower Interest Rates
You can analyse the impact of tax deductions on the bank interest rate. If you are being charged 10% for your loan by the bank and got to pay 30% taxes to the government, there’s an advantage of taking a loan, which you can deduct. This also makes it easier to budget, and make financial plans as well.
Drawbacks and Possible Alternatives
Every good thing comes with a price. Even for debt financing, you must keep a few points in mind before you choose to advance.
Your sole obligation to the lender is to make your payments on time, irrespective of the current financial position of your company. Even if your business fails, you’re still bound to clear off the debts without making a hesitation. And your lenders will have a claim to repayment before any equity investor if you are forced into bankruptcy. Secondly, the interest rates may vary with macroeconomic conditions, even after you calculate the discounted interest rates from tax deductions. And lastly, you may also need to provide collateral to the lender, which would put some of your business assets at potential risk.
Equity financing may be considered as an alternative to debt financing, which involves selling shares of your company to interested investors or putting some of your own money to the company. Mezzanine financing is often recommended, where the interest rates are considerably high but no collateral is entertained. But most companies prefer hybrid financing, which is nothing but a combination of equity and debt financing to fund their ventures.