Here is a clear demarcation to find the right debt-to-equity ratio for your business.
Surplus cash is necessary to run a small business successfully. At times, the financial standing of the company is not strong enough to withdraw cash, and the liquidity position is disrupted.
In such scenarios, raising loans through banks for small business or relying on individual investors becomes unavoidable. However, raising small business loans poses a challenge for startups, and business owners struggle to find the right capital structure or funding mix for their company. Differentiating between the two funding options, debt and equity, raises issues. In this regard, a clear demarcation between the two and the cost of capital to be incurred will help entrepreneurs make the right financial decisions, ensuring business growth and higher valuation.
What's the difference between debt and equity funding?
Debt financing is a process of arranging funds for your business through borrowings. These borrowings can be in the form of secured or unsecured loans that will eventually have to be paid back to the lender at a certain interest rate. On the other hand, equity financing is a process of raising funds by selling off part of stocks of your business, or shares. Under this type of funding, ownership of the business is traded off in return of funds.
Is debt or equity better?
While the key underlying difference between the two 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 a greater sum than the amount repayable to the lender, making it a costly proposition. Moreover, the loan has to be repaid regardless of whether 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 a business's income. Dividends paid under equity funding are not tax-deductible.
What risks are involved?
Both types of financing carry a certain amount of risk that you must account for before making a 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 are not in sync with your business goals. Similarly, with higher-debt funding, the company's financials represent a high debt-to-equity ratio. To banks, a high ratio is not a sign of a healthy business, and they fear losing money. As a result, taking out loans for the company becomes difficult in the long run, because it suggests the company does not have adequate liquidity and may go bankrupt.
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Apart from this, with continued debt funding, the growth of the business is limited and restricted. The loan has to be repaid within a scheduled period of time and eliminates surplus cash that you could otherwise use to expand the business. In the case of equity, on the other hand, the funds are not repaid and can be used to expand your business's horizons. However, based on the agreements you sign with investors, dividends must be paid out within the given timelines. Failure to do this will negatively impact your business.
How should you choose between debt and equity?
To determine the optimal capital structure for your business, you must ascertain the cost of capital involved in raising funds. In the case of 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, the cost of capital of about $6,000 will have to be repaid over and above the principal amount.
When you choose equity as your funding method, the cost of capital is calculated through the capital asset pricing model (CAPM). This is the formula: CAPM = (risk-free rate)/(company's beta x risk premium)
This finds the value of the larger investment market and the relative value of the company's stock (represented by beta). Based on these parameters, you can determine the cost of funding debt and equity.
Find a mix between the debt and equity that will yield the best funding option at a reduced cost of capital. The mix should minimize the cost of capital and the risk of bankruptcy.
What your business desires is funds at your disposal, but a capital structure of the company is evaluated with debt-to-equity ratio. If too low or 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 and buildings can be more highly leveraged. Following these key principles will surely help business scale heights and overcome financing impediments.