Debt is a good option to raise money to grow your business without giving up the freedom to operate
Mohd Haroon is a happy man. Last year, this founder and managing director of Noida-based auto parts company Aglow Engineers wanted to grow his business, for which he needed to buy more sophisticated machinery.
Haroon looked around for options to raise money and finally zeroed in on J&K Bank. He took a loan of Rs 35 lakh at 11.5% interest, to be repaid in five years. Haroon has had a good working relationship with the bank, from which he has been taking working capital loans to meet his company’s day-to-day needs. Since the amount needed by Haroon was low, he did not even consider the option of going in for equity financing. Now he is targeting a turnover of Rs 8-9 crore in the next five years, as against Rs 2 crore at present.
very business, no matter how big or small, needs money to meet its short-term, medium-term and long-term capital requirements. While short-term requirements are aimed at meeting daily expenses, those relating to medium- and long-term are aimed at scaling up the business to increase the value of the company.While for working capital loans companies look up to banks, when it comes to making big investments, they have to take a tough decision—either go for pure debt, pure equity or mixed financing. It is widely believed that companies prefer to bootstrap first, which means relying on their internal resources such as savings, family and friends. If that falls short of requirement, they go in for debt, and lastly, they opt for equity. The equity option for small and medium businesses is in the form of angel funding or venture capital, while the same for large businesses is raising money from financial markets, which involves launching an IPO. Debt options are in the form of bank loans and bonds.
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What is debt financing?
Debt financing refers to borrowing money from a source outside the company under certain terms and conditions relating to interest rate and the period of return of the principal amount. Most entrepreneurs prefer to start their operations with the money borrowed from banks and financial institutions. But this does not mean that large corporates are averse to taking loans. In fact, most big businesses have a debt component in their balance sheets, the reasons for which could vary from tax breaks, low interest funding or big acquisitions.
But the option of debt financing may not be open to some sectors at all. For instance, startup technology companies. This is because they have no assets to offer as collaterals. According to Jayant Tewari of Outsourced CFO and Business Advisory Services, “in the technology space, debt is fundamentally not available. This is because there is no asset base that can be securitized as most firms operate out of rented premises. The only asset they can lay claim to is hardware. Thus debt as an avenue of funding is not available.” However, “to some extent, they can do a little bit of leasing on their hardware, which is negligible, This too does not apply to startup firms,” he adds.
But for large corporates, sometimes, equity is more attractive that debt and it is also easy to come by based on their reputation. “If you are an Infosys or a Wipro, then you are giving equity at par. Take the case of Reliance Power IPO priced at Rs 450. You are giving 10 rupees share to get Rs 450. Thus Rs 440 comes without any cost. In this case, equity becomes ideal. This is because you manage to sell equity based on your image in the market,” says S Padmanabhan, Director, Padmaja Financial Services.
Pros and cons of debt financing
Pros
• Autonomy: This is a big reason why going in for debt is considered to be a better option vis-à-vis sharing a part of your company with the lender during equity financing. Raising a loan leaves you with the freedom to run the company the way you want to, without any interference from the lender, as long as you meet your re-payment requirements.
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| A company should look at its own cash-flow situation, based on which it should take a decision on debt financing. — Pankaj Jain Director and CEO Finman Venture Consulting |
• Tax benefits: Interest payments on loans are deducted from the company’s income before calculating taxable income. This reduces the tax burden, thus making debt a favorable option for both small and big firms.
• Discipline: Some experts believe that managers of firms that have no debt and generate high income tend to become complacent. This may lead to inefficiency. On the other hand, managers who work with companies that have a debt burden have to be on their toes to ensure that enough income is generated to service the debt.
Cons
• Repayment: One needs sufficient cash-flow to keep servicing debt. Failure to do so may result in lenders taking legal recourse to recover their money. This could even result in bankruptcy. The lender is not concerned whether your business succeeds or fails, as long as you are making repayments on time. Even if your business collapses, loans have to be repaid to avoid getting into legal hassles.
• Interest rates: The rate of interest may vary depending on the source of financing and your company’s credit rating. So it is important to look for a good deal. Companies with poor credit rating are offered to pay higher interest rate, compared to those with a good credit rating. Higher the debt on your balance sheet, greater the difficulty in getting a good credit rating.
• Collaterals and guarantees: Most loans come with riders. You have to provide collaterals, which could be the ownership papers of your company. At times, you may need someone to guarantee the return of loan amount on your behalf. These may act as dampeners, as you see a part of your company lying with the lender.
However, Pankaj Jain, Director and CEO, Finman Venture Consulting believes that the advantages and disadvantages of debt financing may vary for different companies. It all depends on the requirements of the company, which may be short-, medium- or long-term. “A company should look at its own cash-flow situation, based on which it should take a decision on debt financing,” he says.
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