Not all debts are bad debts. Borrowing can be good at some times as understood by the high standard financial set. Debt can be effectively used to gain leverage, which is definitely better than being weighed down totally. The notion of owning money is taken is a negative sense, which is very wrong.
The daily financial sensors highlight the negative side of borrowing. All you hear these days is the negatives of money such as increasing national deficit, extensive credit card spending, student loans etc. Nevertheless, the real case scenario is not that bad. Borrowing can be good and the following measures will make you believe so.
Giving up equity is an expensive option
There are certain facts that you need to know about running a business. Knowing that giving up equity is an expensive option in the longer run in comparison to borrowing, is one such fact. Giving up equity involves you costing a noticeable portion of your business forever. In some cases, though giving up a portion of your business seems to be the wiser option but the question is how to make the right decision as in majority cases it is an expensive measure. Financial structures and measure helps you take a better decision in such cases.
Calculate the expected cash flow on discounting basis that you had been giving up for equity investment. If the expected cash flow is greater than the cost of the debt then you are in a position that is better off getting debt in the business. In general scenarios, debt in the longer run will help keeping your equity intact, as you only incur the interest costs that is capped and temporary.
Comparing debt to the opportunity cost
Depending upon the right opportunity debt mostly seems to be a better choice. Debt can help you earn profits and explore newer growth channels. When the return from debt is higher than the cost of debt then borrowing is the right choice indeed. Let us consider an example to this.
You are new in business and have opened up a shop. You have a consideration to fulfill the first order that you have received but you do not possess enough capital to buy the inventory. Now you have the option to borrow debt of $10,000 at the cost of $2,000.
Calculate the APR on the debt and compare it to the return on investment. Say APR on the loan is about 520 percent on a two weeks loan, with availability of cheaper debt and the rate on investment is $30,000. The profits after considering the inventory costs and other costs, amount to say $18,000. Here the opportunity cost of avoiding the interest cost is huge. Therefore, borrowing is definitely the best option.
Reduction in the tax burden
Most of the entrepreneurs are not aware to the benefit of reduction in tax burden in lieu to payment of interest on debt. Paying interest on the debt reduces the amount of profits that are taxable and thus, reduces your tax burden indeed. This strategy of factoring lower cost of capital in calculation of return from debt helps in improving the finances of the company.
This is major point of difference between the equity and debt. Debt helps in financing the business growth and equity does not. Debt benefits you by lowering your taxes, while in the equity concept you only pay off the equity holder without any significant benefits to you.
Debt has the ability to instill discipline
Debt has the potential to bring discipline with itself. It standardized your spending and investing habits helping you build a stronger base in the growth years of business. Debt ensures that you aim to put every dollar to optimal use. With the sword of debt hanging on your head, your every decision is financially justifiable.
Borrowing is considered a better option than giving up on equity as it enhances the growth prospects with a number of positives like reducing tax burdens etc.