What are the advantages and disadvantages of the debt finance

  1. What are the advantages and disadvantages of the debt finance

According to Panteghini (2008), debt financing refers to money borrowed from the outside sources for a company to run its business or a kind of new investment to a business up on an agreement of the repay the capital on a certain applicable interest in a set schedule. And as the major source of funding, the debt finance owns both advantages and disadvantages to the company, shareholders as well as lenders.

  1. To the company

On the one hand, there are several advantages of the debt finance to the company. First, debt finance enables the company to maintain its ownership on the business control as the borrowers, compared with other kinds of finance means such as the equity finance which needs the company to share its ownership and decision making process partially. That is to say, in the debt finance, there is seemed no monetary interest in the business for the third parties except for the interest and some principal income. Second, debt finance also enables the company to maintain its profit gained from its business by itself rather than sharing with its debtors. That is to say, the debtors of the company only own the right to get the loan paid-off timely without any share in the profit gaining by this company. Third, debt finance enable the company to only afford limited obligation compared several other finance measures. For example, in the debt finance, the obligation of the company as the borrower will be end up with the payment of the principal as well as the set interest to the creditors and from then on there is almost no obligations of the company to the creditor unless new debt occurs. Fourth, one of the most attractive points of the debt finance for the company is its advantage in tax deduction. That is to say, there is a tax deduction n the interest paid towards the borrowed money for the company, which is helpful for company to save money on its tax liabilities. (Berger 2005)

On the other hand, there are also some disadvantages of the debt finance for the company. At first, compared to other kinds of finance means such as the equity financing, company has no choice but to repay its debt without further related to its financial status namely whether this company makes profit or not it must pay back its debt timely. Second, the debt finance may also restrict the cash flow of the company. In the debt finance, the debt often works as the fixed obligation for the company ignoring the profit, loss and other financial status, which may cause some risk in insolvency of the business particularly in the financial downturn period of this company. Third, debt finance may also restrict the freedom of company to choose other financial alternatives when the company still affords some debts. Fourth, the fixed interest occurring in debt may also increase the point of the break even for this company or even the point in which there is no profit or no earning of this business as well. (Berger 2005)

ii) To the shareholders

In the first place, as one of the advantages of the debt finance for company is the control right on the business. First, as the most important stakeholder of the company, shareholders enjoy the same right. As a large proportion of the capital is raised by these shareholders and the shareholder who owns the largest amounts of the shares is the actual boss of the business. And for other shareholders whether they are big or small, if the company has the control on the business, the shareholders have more direct right on the business control as well. Second, since there is no need or no obligation of the company to share its profits with its lenders, its major obligation to the lender is to pay off its debt on time with negotiated amount and interest, that is to say the profit earned by the company will not be shared with another parties and the much the company gain, the much the shareholders of this company will earn. Third, debt finance is also a less expensive means for the business, because the repayment of the capital can be paid installment lasting for many months, which give the business relatively enough time to run its business and reach the mature of the investment. If this good result does happen, the return for the shareholders is also considerable and the pressure for shareholders will also be less due to the repayment by installment. (Panteghini 2008)

In the second place, there are also some disadvantages of the debt finance to shareholders as well. In fact, the shareholders and the company often work as a community in benefit. The gaining of the company indicates the gaining of the shareholders, vice versa. So the disadvantages for the company will also arouse many disadvantages for its shareholders. First, debt finance regulates company to pay off the debt according to its commitment to its lenders no matter whether it gains or loss. So for the shareholders, there is also high risk to face an embarrassing situation that the company may not have a good financial performance as the expectation, and even it can’t pay off the debts its owns. Under such circumstance, there is a danger for the business to go bankrupt, which may indicate the investment of these shareholders may not return, let alone earn money. (Panteghini 2008)

iii) To the lender

In terms of the advantages of debt finance to the lender we can also find out these points. First, as the repayment of the loans is fixed which will not changed even there is a loss in a business. That is to say, the return of the loans from the lender is relatively steady and with relatively smaller risks since the repayment of the loans is paid in installment. Second, as we have noticed there is a fixed interest occurring in the loans from the lenders. That is to say, besides gaining back the original amount of the money lent to the company, lenders can also get certain amount of interest according to the amount of money lent to the business, which is often a considerable of income for the lenders. Thirdly, debt finance is also relatively easy to manage. There are no extra or complicated requirements on the reporting for the lenders to invest too much time and energy to deal with because the repayment timeline and interest are set primarily. In this point, it is also a time saving measure in the material processing aspect for lenders to lend money to business. (Young et al. 2008)

In the disadvantages of debt finance, there are also some aspects for the lenders. First, as we have observed, the repayment of the loans in debt finance is also set in installment and the full paid off of many loans may last for many months or even years, which may cost the lenders a longer time to return its capital and have some influences on its business with other borrowers. Second, as every business has some potential risk including the debt finance. Although there are many successful examples of companies depending on debt finance, there are also risks for the failure of the business depending on debt finance. If the company can’t manage the business well and make proper financial strategies on the loans repayment issue, it may become insolvent when it can’t carry out its promise when the due day of repayment coming. If this situation happens, lenders may also face a certain amount of loss. (Young et al. 2008)

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