What You Should Know about Financing a Business
To run a business, you need financial backing, otherwise known as capital. A business raises capital by buying things on credit, waiting to pay some expenses, borrowing money, getting owners to invest money in the business, and making profit that is retained in the business.
Borrowed money is known as debt; capital invested in the business by its owners and retained profits are the two sources of owners’ equity.
Accounts payable, accrued expenses payable, and income tax payable are short-term, non-interest-bearing liabilities that are sometimes called spontaneous liabilities because they arise directly from a business’s expense activities — they aren’t the result of borrowing money but rather are the result of buying things on credit or delaying payment of certain expenses.
It’s hard to avoid these three liabilities in running a business; they are generated naturally in the process of carrying on operations. In contrast, the mix of debt (interest-bearing liabilities) and equity (invested owners’ capital and retained earnings) requires careful thought and high-level decisions by a business. There’s no natural, or automatic, answer to the debt-versus-equity question.
The advantages of debt are:
Most businesses can’t raise all the capital they need from owners’ equity sources, and debt offers another source of capital (though, of course, many lenders are willing to provide only part of the capital that a business needs).
Interest rates charged by lenders are lower than rates of return expected by owners. Owners expect a higher rate of return because they’re taking a greater risk with their money — the business is not required to pay them back the same way that it’s required to pay back a lender. For example, a business may pay 6 percent annual interest on its debt and be expected to earn a 12 percent annual rate of return on its owners’ equity.
The disadvantages of debt are:
A business must pay the fixed rate of interest for the period even if it suffers a loss for the period or earns a lower rate of return on its assets.
A business must be ready to pay back the debt on the specified due date, which can cause some pressure on the business to come up with the money on time. (Of course, a business may be able to roll over or renew its debt, meaning that it replaces its old debt with an equivalent amount of new debt, but the lender has the right to demand that the old debt be paid and not rolled over.)
If a business defaults on its debt contract — it doesn’t pay the interest on time or doesn’t pay back the debt on the due date — it faces some major unpleasantness. In extreme cases, a lender can force it to shut down and liquidate its assets (that is, sell off everything it owns for cash) to pay off the debt and unpaid interest.
Just as you can lose your home if you don’t pay your home mortgage, a business can be forced into involuntary bankruptcy if it doesn’t pay its debts. A lender may allow the business to try to work out its financial crisis through bankruptcy procedures, but bankruptcy is a nasty affair that invariably causes many problems and can really cripple a business.