The ability to raise capital is important for businesses because it allows them to expand and purchase assets to increase profits. Businesses typically have two ways to raise funds – debt and equity financing. Debt financing deals with borrowing money and repaying it with interest. There are advantages and disadvantages to raising capital through debt financing.
A primary advantage of issuing bonds and borrowing money from lenders is that a company maintains complete ownership. This is not the case with equity financing because stockholders have ownership rights in a company.
The benefit of maintaining ownership is that management has complete control over the decisions made on behalf of the company. Management also has the ability to choose its own board members. The only obligation a debtor has to a lender is to pay back the principal and interest.
Another advantage of debt financing is that companies receive tax deductions for the interest paid on debt. In most cases, the Internal Revenue Service considers the interest paid a business expense and allows businesses to deduct the payments from their corporate income taxes. This is beneficial for businesses because it allows them to use the money saved to grow the business.
Businesses using debt financing to raise capital have more flexibility than those using equity financing because they are only obligated to the investor or lender for the repayment period. After all money is paid back, the business is completely free from its obligation. Companies also have greater flexibility because the paperwork to obtain debt financing is less complicated and less expensive than equity financing.
A disadvantage of debt financing is that businesses are obligated to pay back the principal borrowed along with interest. Businesses suffering from cash flow problems may have a difficult time repaying the money. Penalties are given to companies who fail to pay their debts on time.
Another disadvantage is that debt financing affects the credit rating of a business. A company that has a significantly greater amount of debt than equity financing is considered risky. A company with a lower credit rating that issues bonds typically will have to pay a higher interest rate to attract investors. Companies who have to pay more in interest may experience a cash flow problem in the future.
Companies seeking debt financing must meet the lender’s cash requirement, which means companies must have sufficient cash on hand. This is difficult for businesses depending on debt financing for a cash infusion. Some companies may have to put up collateral to qualify for financing, which puts assets at risk if they fail to repay the debt.