Debt can take many forms, but for most entrepreneurs, it will take the form of bank loans or loans from friends and family.
The main advantage of financing your business through debt is that your ownership interest doesn’t get diluted. There are also tax advantages to using debt to finance your business. You can deduct the interest charged on the money you borrowed from your business income and, if your business takes a loss, from any other income you may have.
Debt can be a good way to add discipline to your management team. That’s because you’ll have to make sure you’re managing the company in such a way as to have enough money available to pay your obligations.
The risks of using debt financing
If your business cannot meet your debt obligations, you risk bankruptcy and losing the capital you or your investors have injected into the company.
Using debt may also reduce your ability to borrow money to finance other projects and thus lead to the loss of opportunities.
For entrepreneurs, equity usually takes the form of owners investing their savings into the business. Some businesses might also be able to attract private investors such as angel investors and venture capital or private equity funds.
The main advantage of using equity financing is that you don’t have to repay it. This makes equity financing a much safer choice than debt financing with respect to the risk of bankruptcy.
And since you don’t have to use your cash flow to repay the money you borrowed, you can use that money to reinvest in your business and pursue growth. A low debt-to-equity ratio also makes it easier to borrow money in the future if you need to.
The downside of equity financing
Equity financing dilutes ownership, which in turn could lower your level of control over decision-making and reduce your share of earnings.
Evaluating your capital structure
To maximize the value of your business, you should try to find a financial mix that minimizes both the cost of capital and the risk of bankruptcy. Your capital structure can quickly be evaluated by calculating your debt-to-equity ratio.
The degree of stability in your business, its ability to provide suitable collateral as security, the interest rate you are charged as well as legal or contractual restrictions on debt are all factors that will influence your optimal debt-to-equity ratio.
For example, a company operating in an unpredictable business environment where a future downturn could impact its ability to repay lenders should have a low debt-to-equity ratio.
Conversely, a company with long-term capital assets, such as buildings or equipment, and predictable cash flows can be more highly leveraged.