For running a small business successfully surplus cash is necessary. At times, the financial standing of the company is not strong enough to withdraw cash and the liquidy position is disrupted. In such scenarios, taking help from external funding sources such as raising loans through banks for small business or relying on individual investors becomes unavoidable.
However, raising small business loans for startup companies pose challenges. Apart from this, businessmen struggle to find the right capital structure or funding mix for the company.
Differentiating between debt and equity, the two funding options, pose issues. In this regard, a clear demarcation between both and the cost of capital to be incurred will help businessmen take the right financial decisions. This will help in ensuring the continued growth of business and higher valuation.
Knowing debt and equity funding
Debt financing is a process of arranging funds for your business through borrowings. These borrowing can either be in the form of secured or unsecured loans that will have to be eventually paid back to the lender at a certain rate of interest. On the other hand, equity financing is a process of raising funds by selling off part of stocks of your business also called “shares”. Under this type of funding, ownership of the business is traded off in return of funds.
Which one is better debt or equity?
While the key underlying difference between both types of funding structure is clear, further distinctions are vital for an entrepreneur to make the right decision.
In the case of debt funding, the downside is the payment of interest which results in exceeding the sum of the amount repayable to the lender, making it a costly proposition. Moreover, the loan has to be repaid regardless of the fact that your business generates revenue.
On the other hand, equity funding dilutes ownership and reduces the controlling stake in the business. The main obligation under equity financing is the need to generate consistent profits to distribute dividends.
Further, debt financing offers the benefit of tax deduction as interest paid on debt can be deducted from the business income. Dividends paid under equity funding are not tax deductible.
Both types of financing carry a certain amount of risk that has to be accounted for before taking the financing decision.
Equity funding is generally classified as high-risk financing because raising too much capital through equity investors would cease your control in the business. The majority owner might try to influence the company and make decisions that might not be in sync with your business goals.
Similarly, with higher debt funding the company’s financials represent a high debt: equity ratio. For banks, a high ratio is not a sign of a healthy business and they fear losing money. As a result, raising more loans for the company becomes difficult in the long-run. It represents that the company does not have adequate liquidity and can turn bankrupt.
Apart from this, with continued debt funding, the growth of the business is limited and restricted. The loan has to be repaid in a scheduled period of time and eliminates surplus cash which can otherwise be used for expanding the business.
Whereas in the case of equity, the funds are not repaid and can be used to expand horizons. But based on agreements signed with investors, dividends will have to be paid out within the given timelines. Failing to do the same will negatively impact your business.
Choosing between debt and equity
In order to determine the optimal capital structure, ascertaining the cost of capital involved in raising funds is required. In case of a debt financing, cost of capital is the interest rate levied on the loan. For instance, a $100,000 loan carrying an interest rate of 6% has been raised from a lending institution. Under this loan class, cost of capital of about $6000 will have to be repaid over an above the principal amount.
When choosing equity as your funding option, the cost of capital is calculated through the capital asset pricing model (CAPM). The formula for the same is-:
CAPM= (Risk-free rate)/(company’s beta X risk premium)
Using the formula the value of the larger investment market and the relative value of the company’s stock (represented by beta) is ascertained. Based on these parameters, the cost of funding debt and equity is determined.
Finding a mix between the debt and equity that will yield the best funding option at a reduced cost of capital. The mix will be one whereby the cost of capital and the risk of bankruptcy are minimized.
While having funds at your disposal is what your business desires but a capital structure of the company is evaluated through debt-to-equity ration. Too low and too high this ratio will have negative implications. Therefore, in the case of business downturns and uncertainties, the ratio has to be lower.
Conversely, a business having a surplus cash and capital assets such as land, building and other investments can be more highly leveraged. Following these key principles will surely help business scale heights and overcome the financing impediments.