A company that operates and needs additional capital for expansion will always favor the use of debt as a source of financing. Using debt has a relatively lower “cost” compared to equity, which is one of the biggest advantages of using debt financing.
There are obvious potential issues, which are considered as risks when debt financing is used. A potential issue is the presence of recurring loan payments. Companies will have to include the payment of interest and principal and deduct these from the company’s cash flows. Another risk is that of bankruptcy. If a company does not generate enough revenues, the result will be the inability of the company to settle its financial (debt) obligations. This may result in bankruptcy, which will ultimately ruin the company’s financial reputation
However, using debt creates an improvement in equity returns for shareholders. The use of debt financing also helps in securing savings due from avoidance of paying high amounts of income tax. This is what they say when financial planners and experts refer to debt as being “tax favored”.
When the company uses debt, the company chooses to retain more profits compared to when the company uses additional money from shareholders (equity). If more money from equity shareholders is required, the shareholders will in turn demand for the proportional sharing of profits from the company. However, when debt is used, the company is only obligated to pay the amount to shareholders after the company has paid its financial obligations .
Debt also provides what is called a “tax shield”. When a company uses debt for financing, the company effectively reduces the amount of income that is taxable. Many taxation guidelines all over the world accept the payment of interest expenses as an eligible deduction against revenues prior to the calculation of taxable income. If the taxable income is lower, then the company pays less tax to the government. This “shield” helps the company from paying more and in reducing the cost of financing that the company acquires when it chooses to use debt as a source of funds . This is shown in the table below where a company that uses debt pays less taxes than a company that does not use debt.
The use of debt financing matters to many companies since it allows them to utilize capital outside of their shareholders capabilities for business activities that are stable. To managers, this means that the more stable the company’s operations are, the less likely company shareholders will pressure the company for more results since the shareholders’ capital can be utilized for new projects that expand operations or venture into other possible business opportunities.
Way, Jay. The Advantage of Using Debt Financing. http://smallbusiness.chron.com/advantages-using-debt-capital-structure-22011.html (accessed October 31, 2014).
Investopedia. Tax Shield. http://www.investopedia.com/terms/t/taxshield.asp (accessed November 3, 2014).
Peavler, Rosemary. Debt and Equity Financing. http://bizfinance.about.com/od/generalinformatio1/a/debtequityfin.htm (accessed November 3, 2014).