Many people view debt as a four-letter word, and indeed, debt may suggest a lack of sufficient cash flow or financial difficulty. It’s also an indication of increased risk and not being able to service your debt repayments could have severe implications on your business.
There is however, a different side to debt. For a start, many large corporations have some levels of debt. It sounds counter intuitive, but taking on debt can be beneficial for your business, as long as it is managed responsibly. We look at the advantages of debt financing in the scenarios below.
1. Debt can help you grow your business
One of the primary ways to grow your business is to take on debt. Many small business owners find themselves at a crossroads when facing rapid growth as they are not able to finance expansions on their own. At this time, access to debt can be a great benefit.
2. You maintain ownership of your business
Almost all businesses that require financing will turn to equity or debt at some point. For business owners that are concerned about control, this is where debt financing offers the most advantage. For a start, business owners are not required to relinquish partial ownership of their business to lenders. Unlike equity financing, you do not have to answer to investors.
3. Debt is cheaper than equity
Debt is the cheaper source of financing for a few reasons. For a start, a firm gets a tax benefit on the interests paid to the lender. In contrast, dividends that a firm pays to equity holders are not tax-deductible. Given the same income potential, more debt also equals to a lower equity base, which will result in a higher after-tax profit or return on equity (ROE). This is especially meaningful when you are trying to boost earnings per share, a key metric that investors use to evaluate companies.
4. You retain your profits
As a business owner, your only obligation to your lender is to make repayments within an agreed time frame. Unlike equity financing, you do not have to share your business profits with equity holders. Further, equity holders take on more risk, and hence have to be compensated with higher returns. This risk materialize in the undesirable event of bankruptcy, where debt holders have the first claim on company assets (collateral), while equity holders share whatever is left in the coffers, which may very well be empty.
5. It helps you build credibility for your business
In the same way that credit cards can help you build a credit profile, debts can help you build relationships with financial institutions. If you consistently make your payments on time, it will be much easier to expand your credit facilities. Others are more likely to lend to your business once you’ve established a good business credit score, which is a testament to the good financial health of your business.
With these reasons, it makes sense that financing the business with debt can be an intelligent decision. However, if there is too much debt and with very little or no equity, then it becomes too risky for financiers to provide financing. This will increase the interest rates on new debt .
Most companies will strive to create a balance between equity and debt funding in ways that will keep their total cost of capital low. After all, financing of a business is its very lifeline that needs to be monitored closely and continuously.