capital structure

Hey there! I do hope you had a good time during Xmas. The year 2016 is fast drawing to a close but I thought I should shoot one blog before 2017 is ushered in. I know that many people have the habit of documenting New Year resolutions and some could be on that agenda now, though deep within me I think good resolutions must be made on a continuous basis during the year, and should not just wait for the start of a new year. It’s up to us individually anyway.

And then, my 2016 closing blog is about debt financing. Probably you might have debt financing for your enterprise as one of your new year resolutions. You never know. I think we should today consider some advantages and disadvantages of debt financing. Don’t you think so? I guess it’s a good way to close the year – instead of blogging about Xmas. Isn’t it? Some of us fear debt like a plague, while others enjoy it and could continue borrowing until the world ends. Strange world with diversity!  So, what are the pros and cons of debt financing?

Now, on the pros (advantages) of debt financing, let me briefly say the following: –

  • Debt financing enables lump sum amount to meet all your requirements. One big advantage of debt financing instead of equity is that you can arrange lump sum money to meet your enterprise financing needs. Never mind the bank guys who have the habit of scaling down what you have requested for. Just scale it up and then when they scale it down you are still where you desire. I do hope they are not reading this blog too. He he he. Just a word of caution – be careful in scaling up. Lump sum monies also enable you to buy assets and finance business expansion easily, and this is why many big businesses rely on this instead of struggling with small monies flowing in irregularly.
  • Financing your business plans without selling part of the business is another big plus. Don’t you think this is a smart move? You don’t lose control or relinquish ownership of the business through debt rather than equity financing – unless of course you screw up the debt arrangement later, and then you open up your enterprise to things you don’t like. Legal requirements are also limited compared to equity. Candidly, you don’t have to part with some ownership rights before you get funding for your enterprise.
  • Interest cost is wholly deductible for tax purposes and this is good for you Mr. Entrepreneur. I hope you agree with me here, don’t you? Of course there are some rules about thin capitalization in some territories, which you need to be aware of. This rule simply implies that if your debt to equity ratio is above a certain limit the tax authorities will disallow a portion of your interest cost and tax it. I will not go into all the details here, but you can consult more. Allowing interest cost to be deductible for tax purposes means that your actual cost of actual is reduced.
  • Good business planning becomes easy with debt financing. If you know the principle and interest installments, timing etc including loan disbursement plan, you should be able to properly plan your cash flows. Beyond cash flow, your procurement, investment, business development etc plans become more definite. Isn’t this fantabulous?

We can now look at the other side of the coin. Regarding the cons (disadvantages) of debt financing, we can consider the following: –

  • Difficulties and inconvenience of arranging debt from relevant lenders can be challenging. Lenders will ask you lots of information, security or collateral, history of debt and repayment record or credit rating, evidence of discipline in managing finances, financial card etc. Have you ever interacted with the type of bankers/lenders who make you feel untrusted entirely? Some only fall short of asking for the location of your grandmother’s grave – to prove your origin and authenticity! For God’s sake, people don’t go to the bank to borrow money and then run away to another planet! There could also be restrictions on activities and management of your enterprise and these are very unpleasant.
  • Complications of managing huge debts and high gearing, such as huge monthly or other periodic repayment commitments etc can also arise. Borrowing technically means using future resources with implications of cash flow challenges including stifled growth as you allocate significant resources to debt settlement later. There are several adverse consequences of high gearing.
  • Profitability consideration especially with high interest also has to be taken into account. Mr. Entrepreneur, I don’t know which part of the world you live in, but if you are doing business in a location where the bank charges you 20-30% interest per annum, then you can probably understand what I’m talking about. I mean, what gross margin do you need to earn in your business, to be able to comfortably pay this interest, cover overheads and still make some profits? It’s crazy, isn’t it? For this matter, please I beg you; do your arithmetic well before borrowing money that will simply wipe off your years of hard work building that enterprise. Do you get me?
  • Possibilities of losing ownership and control of the enterprise create a real threat especially if you borrow too much or fail to properly manage the debt. I mean real – not imaginary. Real in the sense that you can feel pain when you pinch yourself! You could also lose assets and other property you have worked very hard to acquire, to some bank or financier that does not deserve it. Come on Mr. Entrepreneur, don’t work for others to enjoy your sweat. The irritating bit is when an asset is disposed of at a tithe of its market value – all in the name of debt recovery. However, don’t say nobody advised you. You are getting that advice here and now as you read this blog. Be smart! Otherwise you may just spring up telling people how bad the bank guys are when they have taken control of your business. Your story will not be pleasant, and only little sympathy may pass by.

And now, I need to run and do some things before 2016 closes. I wish you all a Happy New Year and until then – cheers! Get ready for a terrific 2017 with good business success and good life.

Also, remember to share this blog with your relatives and friends. OK?

Respectfully,

The Wise Entrepreneur

 

December 31, 2016

The Advantages and Disadvantages of Debt Financing An Entrepreneur Should Know

Hey there! I do hope you had a good time during Xmas. The year 2016 is fast drawing to a close but I thought I should […]
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