At some stage, you will require funding to either fund capital equipment, working capital or just to make ends meet during a quiet month.
You can either obtain funding from a financial institution in the form of a loan or obtain equity finance from an investor, or access a combination of debt and equity.
Here, we explain the difference between debt and equity and the advantages and disadvantages associated with each option.
Loans from financial institutions are classified as debt. Debt can be either secured (where the assets of the business are offered as collateral against the debt) or unsecured (e.g. overdraft or revolving loans).
Due to the lower risk associated with secured loans, these generally attract a lower rate of interest than unsecured loans.
Interest is also tax deductible, thus providing a valuable tax shield in the form of lower income tax. Also, the business does not give up a stake in the business.
Secured debt generally attract a lower rate of return than unsecured debt due to the investor not sharing in the risk associated with running the business, i.e. the business has an obligation to repay the loan together with interest irrespective of the profitability of the business.
Shareholding in a business is classified as equity. Shares are purchased by investors in return for dividends and an increase in the value of the business (resulting in an increase in the value of the shares)
Equity consists of profits generated by the business as well as shares sold to investors. Dividends paid to investors reduces the equity.
As a business grows its profits, the value of equity increases, resulting in an increase in the value of the shares.
The biggest advantage of equity funding is that there is no obligation to pay returns to investors. The excess cash can be used to fund business growth.
However, due to the higher risk associated with equity funding, it is generally a more expensive form of finance. It is also not tax efficient, as dividends paid are not tax deductible.
The ratio of debt to equity is called gearing.
It makes sense for a growing business to leverage debt to grow the business. Provided the business is able to make a profit in excess of the interest obligations, and meet the cash flow obligations associated with repaying the loan, the business will grow at a faster rate than using equity. This is because debt is cheaper than equity due to the lower risk profile, as well as the benefit of the tax shield provided by interest payments.
However, should the business not grow as expected or run at a loss, the interest payments and associated capital repayments are due irrespective of the ability of the business to pay these as they become due. In this case, the business risks legal action from funders or, in a worst-case scenario, liquidation.
The best capital structure for any business is a structure that combines both equity and debt in a way that takes into account the business’s unique circumstances and risk profile. This will ensure a structure that allows for growth without burdening the business with onerous debt repayment obligations.
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