Question

What is the relevance or importance of Debt for a firm? Also what are some of the examples of Debt for a small retail firm?

Answer 1

Relevance of Importance of Debt for a Firm -

Companies often use debt when constructing their capital structure because it has certain advantages compared to equity financing. In general, using debt helps keep profits within a company and helps secure tax savings. There are ongoing financial liabilities to be managed, however, which may impact your cash flow.

1. Lower Financing Cost - Compared to equity, debt requires lower financing cost. That's because debt is finite – you are contractually liable to make periodic interest payments and return debt principal for a fixed period. After that, the debt is paid off. Equity, on the other hand, is infinite. Once you have sold a stake in the company, you're going to be paying some of your profit to the equity holder forever. Imagine that you're going to be making $150,000 a year. Would you rather pay $15,000 in interest for a limited period of, say, five years, or give up 10 percent of your profits forever? A safer debt investment requires less cost compensation.

2. You Keep the Business Profits - While using debt may add pressure to a company’s ongoing operations as a result of having to meet interest-payment obligations, it helps retain more profits within the company compared to using equity. That's because equity requires the sharing of company profits with equity holders. Using debt, companies need to pay only the amount of interest out of their profits. Using equity, on the other hand, the more profits a company makes, the more it has to share with equity investors. To take advantage of such a debt-financing feature, companies often use debt to finance stable business operations in which they can more easily make ongoing interest payments and, meanwhile, retain the rest of the profits to themselves.

3. Maximize Effect of Financial Leverage - Using debt is also advantageous to existing owners because of the effect of financial leverage. When companies use debt to provide addition capital for their business operations, equity owners get to keep any extra profits generated by the debt capital, after any interest payments. Given the same amount of equity investments, equity investors have a higher return on equity because of the additional profits provided by the debt capital. As long as using debt doesn’t threaten the financial soundness of a company in times of difficulties, equity owner’s welcome certain debt uses to help enhance their investment returns.

4. Interest Deductions Means Tax Savings - Using debt helps lower a company’s taxes because of allowable interest deductions. Tax rules permit interest payments as expense deductions against revenues to arrive at taxable income. The lower the taxable income, the less taxes a company pays. On the other hand, dividends paid to equity holders are not tax-deductible and must come from after-tax income. Therefore, tax savings help further reduce a company’s debt financing cost, which is an advantage that equity financing lacks.

Examples of Debt for a small retail firm -

• Loans from family and friends
• Bank loans
• Personal loans
• Government-backed loans
• Lines of credit
• Credit cards
• Real estate loans