When you run a business, coming up with the necessary money to pay for expansion can be challenging. You have the option of issuing equity in the business or taking on debt. Tax-paying entities may lean towards issuing debt because of the potential tax savings. At the same time, issuing debt has a few potential drawbacks to consider.
One of the advantages of taking on debt for your business is the tax savings. Anytime a business pays interest on a debt, this amount can be deducted from taxable income. By reducing the company's taxable income, you also reduce the tax liability for the business for that particular year. Although you will have to make payments of principal and interest on the loan, the interest that you pay actually helps your financial situation when it comes time to file your tax return.
Keep Future Earnings
One of the advantages of issuing debt is that the company gets to keep future earnings once the debt is paid off. Once the debt is paid off, the owners of the business the longer have to share the profits. In the case of issuing equity, the owners of the business would have to continue sharing profits long after a debt would have been paid off. This means that the owners of the business get greater long-term rewards by using debt.
Less Attractive Position
One of the drawbacks of taking on debt as a company is that it makes the business look less attractive. Both lenders and investors will be less likely to want to invest in the company. Investors will look at the debt to equity ratio of the business to determine how likely it is to default. If the company has a large amount of debt, it means that the company is in a riskier position and could present some challenges to investors.
Increase Break Even
One of the drawbacks of taking on debt is that it increases the break-even point for the business. By comparison, when the company takes on equity, nothing has to be paid back. With debt, the company has to repay the debt plus interest. This represents a fixed cost that increases the amount of money that the company has to generate in order to stay in business. If the company cannot generate enough money, it will go out of business quickly.
Luke Arthur has been writing professionally since 2004 on a number of different subjects. In addition to writing informative articles, he published a book, "Modern Day Parables," in 2008. Arthur holds a Bachelor of Science in business from Missouri State University.