Debt vs. Equity
Striking the right balance between debt and equity financing can be crucial to the success of your business and the profits that you take from it. Understanding key aspects of the two is the most important step in striking that balance.
DebtDebt is any liability the business incurs that results in a financial obligation and while generally many people frown on incurring debt it can actually be a useful financing tool.
- Payments: You need to consider the required payment terms of any debt financing (i.e. leases, lines of credit, long term loans) and the ability of the company to make those payments. Creating a cash budget for the entire term of the debt is important and ensures you can be comfortable in your ability to make payments. Many forms of debt can come with a ‘grace period' where for several months or a year no payments are required, but really those payments are simply added to the remaining payments when you have to start using them.
- Use of Funds: One thing it is always important to consider is the return that you expect to earn on the funds you are borrowing. If you're expanding your business, what is the return you are expecting on that expansion? If you're funding operations of the business, what is the return on investment that you're currently seeing in the business? Preparing a budget to project this out is important as if the return on investment is less than the interest on the debt, it's likely not a good idea.
- Leverage: The key reason companies incur debt is to leverage the investment they've already made in a company to grow further while not having to bring in additional owners. This is the single most advantageous aspect of using debt to grow as once the debt is repaid you still have the same ownership interest.
EquityEquity refers to giving up an ownership stake and the right to participate in the success of the company in order to secure funds. Key aspects to consider when funding through equity include:
- Control: It's important to consider whether or not you are willing to give up some of the control in your company that equity represents. This can be a major factor for owners looking to expand.
- Financial Obligations: The attractive aspect of funding through equity is that you are in a position to get extra cash with no outright obligation to pay it back, except through the share of ownership given up. If the company struggles the additional investor struggles with you and you're not in a position of having to make debt payments in an already tough environment. Furthermore, unlike debt and having to make repayments, equity is cash flow friendly and doesn't automatically add a need to pay out cash every month. This can be a major consideration if cash flows are something a business needs to carefully manage.
Debt vs. EquityUltimately choosing the right balance in debt vs. equity as a business owner is something to carefully consider and depends on many factors. Cash flow sensitivity, concern over control, and the ultimate use of the funds all vary from business to business and individual to individual. Considering the points above will help ensure you make the appropriate decision for you when balancing debt vs. equity.
By Jeffrey Glen
Posted in ...Business