In moden times debt financing has been a major method used by business to finance their operations. Debt usually refers to that which is owed. Refering to asset, debt is a means of using future purchasing power in the present time before a summation has been earned.
Debt financing is the process where firm raises working capital or capital expenditure by selling bonds, bills to institutions or investors. The investors become creditors and receive a promise for the payment of the principal and interest at an agreed rate and time.
Types of Debt
Small business uses different type of debts to finance their operations. These various debts can be divided into the following categories.
1. Secured Debt
A debt is considered secured if creditors have recourse to the asset of the company on a proprietary basis or in case of general claims against the company. secured debt is divided into the long term and the short term debt.
2. Unsecured Debt
In unsecured debt the creditors do not have recourse to the assets of the borrower to satisfy their claim. This makes unsecured debt very risky to the creditors. As a result of this risk, the unsecured debt normally attract high interest.
Effect of Debt Finance on Small Business
Knowing the effect of this type of on small business is necessary before making it a choice of finance for your small business.
Debt appears as a liability to the company. Capital and interest repayment is made regardless of the business cash flow. In the event of bankruptcy debt holders are secured and they will be paid first.
This type of is easy to secure by small business. This can easily be done through a bank or financial institution. Another advantage of this type of finance is that it does not dilute the ownership of the business. src="https://pagead2.googlesyndication.com/pagead/show_afmc_ads.js">
Advantage of debt over equity
The following are some of the advantages of debt over equity financing: over equity financing:
1. Utilization of Resources
When a business use debt to finance its operation, they got no option than to fully utilise their resources because they will have to payback the debt and interest to their creditor.
2. Short Term Needs Debt finance can easily be secured on a short term bases. This make it very advantagious to the small business as finance of this type can easily be secured for short term business needs.
4. Tax Advantage Debt financing also offers tax advantage to business as interest is deductible for income tax purposes.
Other advantages includes:
• Lenders has no direct claim on future earnings
• Debt does not dilute the ownership of your small business.
• Lenders are only entitled to loan repayment and interest on loan.
• Interest and principal repayment are based on fixed percentage and can be forecast.
disadvantage of debt over equity
1. The main disadvantage of this type of financing is that it requires a small business to make regular monthly payments of principal and interest.Because of shortage of cashflow experience by young business it is usually difficult to make regular payment of to creditors.
2. Most lenders provide severe penalties for late or missed payments, which may include charging late fees, taking possession of collateral, or calling the loan due early.
3. Failure to make payments on a loan, even temporarily, can adversely affect a small business's credit rating and its ability to obtain future financing.
4. Another disadvantage associated with debt financing is that its availability is often limited to established businesses. Since lenders primarily seek security for their funds, it can be difficult for unproven businesses to obtain loans.
5. The amount of money small businesses may be able to obtain via debt is likely to be limited, so they may need to use other sources of financing as well
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