The pros and cons of debt financing
If you rely on debt and have cash flow problems, you will have trouble paying the loan back. Additionally, too much risk could limit your ability to raise equity financing as the business will be seen as ‘high risk’
In the early stages of development, firms need cash to sustain and/or build their business. The type of financing your company needs depends on the requirements you have. There are two primary forms of financing, debt financing and equity financing. Debt financing simply means borrowing money and not giving up your ownership. Thus, when a firm raises money for working capital or capital expenditures; it borrows cash from a bank or lender or any other financial institution at a fixed interest rate. Based on the conditions in the borrowing agreement, the principal amount plus interest must be paid back in full by the predetermined maturity date. Fixed installments are usually paid back to the lender to cover the loan amount.
Equity financing, on the other hand, is raising capital in exchange for shares or ownership in your company. You could offer shares of your company to family, friends and other small investors as well as venture capitalists or angel investors. In contrast to debt financing, you do not have to pay the money back if the company fails. Furthermore, the funds raised are interest free, however, you lose ownership of part of the company equivalent to the amount received from the investor. In equity financing, you do not need to pay installments to repay the funds raised, the lender shares the risk of the company.
Just like any other funding, debt finance too has advantages as well as potential drawbacks.
Advantages
Retain control; the relationship is at arm’s length. Thus, the bank or lender has no say in the way you run your company. The business relationship ends once you have repaid the loan in full.
The interest you pay is tax deductible (in case of taxable environment, not necessarily applicable for the UAE), which effectively reduces your net obligation.
You know exactly how much principal and interest you will pay back each month. This makes it easier to budget and make financial plans.
Loans can be long and short term.
Disadvantages
If you rely on debt and have cash flow problems, you will have trouble paying the loan back. Additionally, too much risk could limit your ability to raise equity financing as the business will be seen as “high risk”.
You need to have a good enough credit rating to receive financing, otherwise you need to provide business or sometimes even personal assets or guarantees as collateral to the bank or lender to guarantee the loan.
You will need to have the financial discipline to make repayments on time. Exercise restraint and use good financial judgment when you use debt.
Money must be paid back within a fixed amount of time otherwise the assets you provided to the lender as collateral could be at potential risk.
Sometimes debt can make it difficult for a business to grow because of the high cost of repaying the loan.
It is vital for SME’s to understand their financing requirements before deciding on debt or equity financing. It is highly recommended to have internal discussions with your finance team or reach out to external consultants that could help you choose the right financing model for your business.