In the starting stages of their careers, the chief executive officers of firms do not think of using debt financing as capital for their organizations' growth. This is because venture capital has a lot more mindshare among them. Many founders are quite anxious about making money with a repayment cap or interest rate attached to it. But they do not have the information that debt is cheaper than equity. Financing a healthy, growing firm with debt is not the same as maxing out on credit cards to fund the development of your product. The firm has to pay its users and even some firms. You may have revenue and even an accounting function. This overall infrastructure makes debt quite easy to account for. You also know about all your repayment obligations well ahead of time. Thus, you can easily plan for them. Also, debt is cheaper than equity because it has some hidden advantages.
This article will show you why debt is cheaper than equity. We will tell you how firms in the beginning stages of their growth can take advantage of using as growth capital instead of mere equity.
Debt financing comes without any taxation. This means that when you go with debt financing, it decreases the overall taxation. It assists in removing the interest that is payable. The interest is usually on the debt of the profits before any taxes. That is why the firms pay less income tax than when dealing with equity financing. There are no elements such as interest on equity in the case of equity financing. But there is the element of dividend present there. The earning before interest and taxes in equity financing is typically more than what is the case of debt financing, and it is usually the same rate in both circumstances. The earnings per share are more in debt financing than equity financing. In the latter, the number of shares is more than before. In debt financing, there is no modification in the number of shares that are present. Now you know why debt is cheaper than equity when it comes to financing.
The owners of firms in the beginning stages do not consider debt as capital for the growth of their firms. Venture capital is usually more preferred by them. Thus, many people are nervous about getting funds with an interest rate. But this does not have to be the scenario. The simple truth is that financing your firm's growth using debt is not the same as using other sources of credit. You have a solid infrastructure and will also know about your repayment obligations. So, you will be able to plan the activities of your organization in a much better manner.
There are a lot of benefits of debt financing that you may not know of. There are some special advantages of debt financing. Suppose your firm is facing some financial issues. In that case, debt financing can give you what equity financing has not been able to. For example, if your firm uses accrual accounting, the interest payment is often a portion of the profit and loss payments. This means that there will be a reduction in your overall taxable income. Thus, the cost of borrowing will be much lower than the interest rate that is stated. The government of the United States will assist you in mitigating the cost of the loan procured. A lot of entrepreneurs have the belief that such venture capital is free money. But the basic reality is that it is not. Debt is the top method to go if you want to make any big progress with your firm. Typically, a lender will not come and tell you how you should be operating your firm. But, by giving up equity in return for funds, you will have the investors on the firm's board. This also means that you will have to bend according to their expectations regarding how the firm should be operated.
Sometimes the control of the owners of such a firm gets restricted. This is because of conflict with the investors. But the lenders are interested in the firm being up to date with the payments. They do not require seats on the board or any type of controlling stake. For the firms in the beginning stages of their development with continuing revenue streams, any minor debt will lead to a growth in the net cash flow. There will be a growth in the overall cash flow with the added funds. You can have some extra hands with this amount of cash. You may be lucky enough to get the right employees. Then, it will reflect well on the overall productivity of your business. This will show in the sales and overall return on investment.
One of the main disadvantages of equity financing is that it typically takes a lot of time to get the funds. It also takes a lot of effort to raise funds using many kinds of meetings. Debt financing is typically a much quicker process. It saves you the time that you need to operate your firm. The lenders are not interested in keeping up to date with all the decisions of the firm. They typically do not require any board meetings. They do not think about your hiring or strategy process. If any organization goes bankrupt, the equity members lose everything they have. The lenders have the first claim on the assets of the firm. This increases their overall security. So, debt has restricted risk and is typically cheaper. But equity holders are taking on much more risk. So, they require to be compensated with greater returns. Some firms raise billions of dollars when it comes to initial public offerings. These firms can afford this type of money because the risk is quite diversified among the many investors. A financial institution or even a group of such institutions would never give such huge amounts to a single borrower.
Debt financing assists in getting the much-required capital to increase its operations. When any firm issues bonds, the individuals who purchase such bonds are investors who give the firm the needed financing in debt. The loan must be paid in the agreed period. If the firm closes its operations, the lenders are free to sell off the assets of the firm to get their funds. The character of a firm during financing is a function of the debt-equity ratio. The lenders are quite motivated by a lower debt-equity ratio. This shows that the firm is more based on investments. It leads to more investor confidence in the organization. There may be a scenario where the debt quietly ratio is quite high. Then it means that the firm has a lot of borrowings on a small base of investment. A firm's overall capital structure is typically composed of debt and equity. The dividend that is given to the shareholders is the cost of equity. The firm pays the interest and the loan when it comes to debt.
The cost of borrowing is the cost of payment of the debt instruments. The sum of the cost of equity and debt is the cost of capital. The cost of capital shows the lowest return. The firm has to make this return on the capital if it wants to satisfy its capital providers, shareholders, and creditors. All the decisions of a firm regarding investments that get returns should be more than the cost of the capital. The returns on capital expenditure are lower than the cost of capital. In such a scenario, the firm is on a positive path.
Not many people know that debt is cheaper than equity. The funding options that you chose today are very important. It will pave what you can and cannot do with your firm in the future. It is important to be aware of all options related to finding in the initial years after launch.