The following is a direct excerpt from Chapter 3: Debt Financing Sources: Overview, from The Funding Is Out There! Access the Cash You Need to Impact Your Business. -TCW Many stable companies with predictable, consistent cash flows prefer debt as their funding choice. Why? Because debt provides the lowest cost of capital, meaning your company pays the least when it uses debt. What does that really mean? Let me explain. When your business takes out a loan on your company’s assets or against your firm’s cash flows, your firm must repay the principal amount that it borrowed and the interest accrued on the loan. Your company may also have had to pay closing costs and other loan-related fees. In general, for small to medium businesses annualized interest rates – which reflect all these costs – range from 5 to 18%, depending on several factors. Therefore, your company’s cost of capital equals 5 to 18%.
Equity, however, does not require any principal repayments or interest payments. (Note that preferred equity may have an interest rate or specified dividend, but the payments accrue if the company has no cash to pay them. Unlike loans, nonpayment does not trigger a default.) Instead, your company must pay a proportionate share of the company’s profits as dividend distributions to its equity holders. In addition, if you sell your company, you must pay a proportionate amount of the sales price to the equity holder.
For example, an investor owns 25% of your company, which generates $250,000 in profit. Your shareholder agreement states that you will distribute 40% of profits as dividends and retain the remaining 60%. You therefore distribute $100,000 in dividends – $75,000 to yourself and $25,000 to your investor. You must do this every year until you either sell the company or buy out the investor. Over a ten year period if your company is profitable, you may return well over 200% of the original investment amount to your investor, significantly more than the 5 to 18% you would have paid in interest on a loan during the same period.
Debt has other benefits. If your company is a manufacturer, equipment distributor, or other asset intensive business, carrying a high debt load on the balance sheet increases the return on assets. In addition, a high number of loans and supplier financing arrangements that you consistently pay on time builds your company’s business credit.
Your company’s balance sheet provides a snapshot of its financial health at a particular point in time. Debt level and type strongly impact the balance sheet. Too much debt increases your company’s financial risks, but too much equity dilutes your owner’s return. In addition to debt financing, your firm can use leases to acquire assets. Like debt, leases categorized as financing appear on the balance sheet as a liability. Profitable companies with high operating cash flow have no difficulty maintaining a high debt load because they generate more than enough cash internally to make the required principal and interest payments.
Companies generally make these principal and interest payments on a monthly basis.
Debt financing involves borrowing money. When you use debt financing to fund growth or operations, you take on loans or similar financing obligations. Unlike equity financing, you do not give up any ownership in your company. You pay back the principal amount you borrowed along with the interest charged on the principal amount. Debt financing often comes with stipulations – referred to as covenants or terms – about how much additional debt your company can take on, how profitable your company must remain, and the cash flow your company must generate. You can deduct the interest on debt from your company’s taxable income.
Debt financing provides leverage. It enables you to stretch the funds you have in owner’s equity to help accomplish company goals.
As a small business owner, your debt will typically occur in the form of loans – lines of credit, term loans or mortgages. Lines of credit and construction loans often operate as interest only loans. Some loans offer partial amortization with balloon payments at the end of the loan’s term. However, most term loans and mortgages fully amortize over the period of the loan.
Copyright © 2014 by Tiffany C. Wright. The above is an excerpt from the book, The Funding Is Out There! Access the Cash You Need to Impact Your Business, published by Morgan James Publishing and currently available on Amazon for pre-purchase in ebook format (release date: August 2014) and in bookstores and libraries in October 2014. All information is copyrighted. No part of this publication may be used without prior authorization from the author. To join the VIP Club and receive freebies, event notices, and special offers, or for an advance copy in eBook or softcover format, please visit www.thefundingisouthere.com .