Benefits-Drawbacks

What Is Debt Financing ?

Debt financing is just opposite of equity financing.(in which capital is raised by selling equity instruments to the investors). It is a process of raising fund by selling debt instruments such as bond, credit cards, debentures etc. It is a borrowing of money and should be paid back with interest. In this post we are going to discuss some major pros and cons of debt financing.

Advantages Of Debt Financing

The main advantages of debt financing can be pointed out as follows:

1. Ownership And Control

One of the main advantages of debt financing is that it does not dilute ownership and control like in equity financing. Ownership, management control remains with the company because lenders have no right to manage the company.

2. Decreased Tax Obligation

Debt is considered as expenses in business. So, interest on loan is tax deductible. So, it minimizes the tax obligation.

3. No Share Of Profit

Another benefit of debt financing is that company can enjoy entire profit because lenders cannot claim on the profit of the firm.

4. Improves Credit Rating

If a firm pays loan and interest on time, it improves the credit rating of the business, It increases the reputation and image of the company.

5. Flexibility

It is more flexible than equity funding. There are several debt instruments such as loan, debenture, bills, credit card etc. Companies can choose best debt financing option as per the nature of the business.

Disadvantages Of Debt Financing

The main drawbacks or disadvantages of debt financing are as follows:

1. Impact On Cash Flow

As we know that certain amount of loan and interest should be paid in each month until the last installment, it may negatively impact cash flow. It may hamper daily operational activities because of lack of adequate working capital.

2. Complex Process

It is difficult to raise capital with debt financing. It requires strong credit history to attract lenders. So, it is not suitable for small and new business firms.

3. Need Of Collateral

Another disadvantage of debt financing is that company may need to provide collateral (fixed assets such as land, building, machinery) etc. to secure loan. If the company fails to repay the loan lenders can acquire the assets.

4. Strict Discipline

It requires strict discipline to repay the loan. If a firm fails to repay the loan on time it negativels affects the credit rating and image of the firm.

Also Read

Advantages and disadvantages of equity financing

5. Not Suitable

Debt financing is not suitable for the business having inconsistent cash flow because it make difficult to pay the loan and interest regularly.

Pros And Cons Of Debt Financing In Short

Pros

- Firms retain ownership and control

- It increases the credit rating of the firm 

- Firm can enjoy 100% profit

- It decreases the tax liability

- Liability is over after paying the loan

Cons

- It is risky and complicated than equity financing

- It may impact cash flow of the firm

- Firms may have to pay high rate of interest

- It is not suitable for small business

- It requires collateral to get loan

What Is Equity Financing ?

Equity financing (also called equity funding) is a process of raising capital by selling equity instruments like ordinary shares, preference shares etc. Companies issue share to investors to raise money for business. It is effective tool that helps to meet short-term or long-term obligation of the firm.

Advantages Of Equity Financing

The main advantages of equity funding can be pointed out as follows:

1. Less Risky

Equity financing is less risky method of financing than debt because firms do not require to repay loan and interest on the raised capital.

2. No Additional Burden

Another benefit of equity financing is that it does not suffer the company with financial burden like monthly repayment of loan and interest.

3. Opportunity To Grow

As we know that firms do not have to repay loan, so firms can invest more money to expand business. Therefore, it provides the opportunity to grow.

4. Raising More Fund

Equity financing can raise more capital than borrowing. So, it is more favorable option than debt financing.

5. Attract Investors

It can increase credibility and image of the company if the raised fund is invested properly. It helps to attract more investors and partners in the future.

Disadvantages Of Equity Financing

The main disadvantages of equity financing can be highlighted as follows:

1. Sharing Profit

One of the major drawbacks of equity finance is that company founders cannot enjoy 100 % profit because it should be share with the shareholders.

2. Costly Method

Equity financing is costlier than borrowing because of higher risk and no tax shield.

3. Sharing Ownership And Control

Another disadvantage of equity financing is that company should share ownership with the shareholders. So, it limits the power and control of founders.

Also Read

Advantages and disadvantages of debt financing

4. Possibility Of Conflict

Because of shared ownership, control and power there exists a possibility of conflict between investors and owners of the company.

Pros And Cons Of Equity Financing In Short

Pros

- It is less riskier than debt financing

- It avoids the financial burden of the firm

- It provides expansion and growth opportunity

- It can raise more capital than borrowing

- It lowers the credit problems

Cons

- It splits the ownership and profit

- It is complex and costly method of raising capital

- It may create conflict between shareholders and owners

- It lacks tax shield

- It is time consuming process

What Is Hire Purchase System ?

It is a method of acquiring expensive assets under which buyer get the right to use products without making the whole payment. He/she obtains the asset by making the partial payment and the remaining amount is paid periodically in installments (interest is added in installment amount). The ownership of the asset remains with the seller and it will be transferred to the buyer after the payment of final installment. Hire purchase is beneficial for both sellers and buyers but it has some drawbacks also. In this post we discuss about the pros and cons of hire purchase system.

Benefits Or Advantages Of Hire Purchase System

The main advantages of hire purchase can be highlighted as follows:

Benefits Of Hire Purchase To The Sellers

1. Market Expansion

Hire purchase allows the customers to use expensive items or products without making the full payment. So, it attracts more potential customers which helps the seller to expand the market.

2. Increased Sales And Profit

It encourages the customers to buy more goods because the payment can be made in installment. So, it helps to increase sales which leads to increase in the profit of sellers.

3. Extra Income

Another benefit of hire purchase to the seller is that he/she can earn some extra income in the form of interest which is added in the installment amount.

4. Less Riskier

Hire purchase system is less riskier than installment system because ownership of the asset is not transferred to the buyer until the final payment. The seller can acquire the product or asset if the buyer fails to make regular payment.

Benefits Of Hire Purchase To The Buyers

1. Suitable For Small Traders

It reduces the financial burden of small traders because they can acquire expensive items such as plant, machinery, vehicle etc. by making periodic payments. It eliminates the complexities of borrowing fund from other sources to run the business.

2. Easier To Buy

In hire purchase system, buyers make payments in installment. So, Customers having lower income can buy required products easily.

3. Immediate Use

Buyers can use the products immediately after the first installment.

4. Tax Benefit

Interest payable is deducted from taxable income which provides tax benefits to the buyers.

Drawbacks Or Disadvantages Of Hire Purchase

The main disadvantages of hire purchase system can be highlighted as follows:

Disadvantages Of Hire Purchase To The Sellers

1. Huge Capital Required

Sellers require huge amount of investment to acquire expensive assets such as car, plant, machinery etc. to run hire purchase business.

2. It Involves Risk

Although the seller can take back the item in case of default payment, he cannot recover the actual cost of the product because value of second hand product is decreased.

3. Increased Bad Debt

If customers do not pay the installment in time, it may increase the amount of bad debt.

      Also Read:

Advantages And Disadvantages Of Leasing

Features Of Hire Purchase System

Difference Between Hire Purchase And Installment

4. Work Load

Hire purchase may increase the workload of the seller because more clerical and paper work is required to maintain sales accounts.

Disadvantages Of Hire Purchase To The Buyers

1. No Ownership Of Assets

Ownership of item is not transferred to the buyer until the final installment. So, seller can repossess the asset in case of default payment.

2. Higher Cost

Sellers add extra cost (interest) in the selling price of the asset. So, buyer has to pay more than the actual price of the item.

3. Larger Duration

It takes very long time to make full payment which may create frustration to the buyer.

4. Risk Of Overspending

It attracts more audience because of the periodical payment system. It may create artificial demand for the product in the market. Buyer may be tempted to buy unnecessary and expensive items. So, higher purchase may encourage overspending.

Pros:

- Sellers can attract more customers which helps to increase sales and profit

- Seller can earn extra income in the form of interest

- There is less risk for the seller because ownership of the good remains with him until the last installment.

- Buyer can obtain expensive item by making small initial down payment

- It may provide tax benefit to the buyer

- It is very beneficial to the small business firms to acquire valuable fixed assets

Cons:

- Large amount of capital is required to run hire purchase business

- There is a risk of default payment

- There exists a chance of increase in bad debts

- Because of the interest, buyers have to pay more than the actual amount

- It encourages overspending to the buyers

What Is Trade Credit ?

Trade credit is a business practice where seller or supplier allows the buyer to purchase goods on credit without making immediate payment. It is a short term agreement (generally 15 to 90 days) and buyer should pay the bill amount before the due date. It is beneficial to new business firms and small traders for short term financing.          

Benefits Or Advantages Of Trade Credit

The main advantages of trade trade credit can be highlighted as follows:

Benefits Of Trade Credit To The Suppliers/Sellers

1. It Helps To Increase Sales

Trade credit encourages clients to buy more products and services because it does not require immediate payment. So, it helps the sellers to increase sales volume which leads to increase in the earnings of the business.

2. Better Customer Relation

Trade credit builds trust between the sellers and buyers which improves customer relation and loyalty. Better customer relation helps to increase repeated customers.

3. Attracts New Customers

Better of better customer relation and trust, it improves the image of the business. Good public image helps to attract more potential customers.

4. Competitive Advantages

Sellers who provide trade credit facility to their clients can increase their sales and gain more customers which helps them to compete with rivals in the market.

Benefits Of Trade Credit To The Buyers/Clients

1. Cost Effective And Convenient Source Of Financing

Trade credit may be the most cost effective and easy source of financing to start a new business because it reduces the capital requirement. It is very useful for those who cannot raise enough fund to commence  business. 

2. Better Cash Flow

It improves the cash flow and helps to maintain liquidity in the business. So, daily business activities can be performed smoothly without facing any financial problem.

3. Incentives And Discounts

Sellers offer incentives for early payment ro encourage their clients. Buyers also can enjoy the benefit of bulk buying.  

Drawbacks Or Disadvantages Of Trade Credit

The major disadvantages of trade credit can be highlighted as follows:

Drawbacks Of Trade Credit To The Sellers/Suppliers

1. Problem On Cashflow

The main disadvantage of trade credit to the seller is that it may negatively affect the cashflow and create liquidity problem. Suppliers may have to face difficulty to pay outstanding bills.

2. Monitoring Problem

It takes paper work, extra time and effort to maintain and monitor outstanding account receivable .

3. Risk Of Bad Debt

Another drawback of trade credit is that there exists a high chance of bad debt. If buyers fail to make payment, it negatively impact business. In this situation, sellers have to suffer from huge financial loss.

Drawbacks Of Trade Credit To The Clients/Buyers

1. Difficult To Obtain

Although trade credit is convenient source of financing, it is very hard for new businesses because they do not have past record. So, suppliers may hesitate to provide this facility to the new clients.

2. High Penalties And Interest 

If buyers cannot make payment on time, then suppliers may charge penalties and interest on debt. It becomes difficult for the clients to repay debt with interest.

3. May Affect The Image

It client fails to make payment by given deadline, then it negatively affect the credit rating that may hamper the image and goodwill of the buyer/client.

Pros (To The Supplier)

- It boosts sales and earnings

- It promotes customer relations and loyalty

- It helps to widen the market 

- It improves the goodwill and image of the firm.

Pros (To The Buyer)

- It is convenience source of short term financing

- It helps small businesses to main better cash flow

Cons (To The Supplier)

- Because of credit sales, supplier may face liquidity problem

- It may increase the bad debt because of default payment

- It requires extra time and work to maintain credit records

Cons (To The Buyer)

- In case of late payment, suppliers may charge higher rate of interest and penalties

- It is very difficult to obtain this facility for new business firms

What Is ABC Analysis Method Of Inventory ? 

ABC analysis of a technique of categorizing the inventory or materials according to their value and importance. Highly valued items are categorized in  class 'A' , least valued materials in class 'C' and less profitable items than 'A' and more profitable than 'C' fall in class 'B'. A strict control is required for highly important and profitable items (group A materials). Average control is exercised for group B and least control is exercised for group C inventory.       

Benefits Or Advantages Of ABC Analysis

The main advantages of ABC inventory analysis can be highlighted as follows:

1. Better Control Over Inventory

ABC analysis system of inventory management gives focus on the control of high priority products (inventory categorized in group A). Strict control over such materials helps to minimize wastage and misuse of most valuable items.

2. Provides Views 

It provides up-to-date information about the quantity and value of stock. It helps the management for decision making and forecasting.

3. Saves Cost

Because of strict control and minimization of wastage, it helps to reduce inventory cost. Materials that falls in group A or high valued products are purchase in less volume which helps to decrease material purchase, handling and storage costs.

4. Better Stock Turnover

Better control, cost reduction and waste minimization leads to increase in stock turnover ratio of the firm.

5. Effective Cycle Counting

ABC analysis provides accurate data about the inventory fluctuations which helps the manager in cycle counting.

6. Economical System Of Inventory

It is more economical than others techniques of inventory management because it does not spend more cost and effort for those materials which are grouped in B and C category. 

7. More Profit

Proper classification of inventory, better handling and cost reduction helps to increase the profitability of the firm.

8. Suitable For Big Firms

ABC analysis system is suitable for big business companies which consumes different types of materials in larger volume.

The main disadvantages of ABC analysis system of inventory management can be highlighted as follows:

1.  It Ignores GAAP

This method does not follow the rules of GAAP (generally accepted accounting principles). Therefore, it is suitable for internal use only.

2. Complex And Time Consuming

It is very complicated task to categorize materials in different groups. It consumes more resources such as time, labor and cost to group materials in case of large group of inventory.

3. Static In Nature

Value of materials may change according to the market trend. It means category A product may move to B and C may move to A with the change in dollar value of product in the market. In such situation, ABC inventory system may become outdated because of the lack of dynamism. 

4. Based On Financial Value

This analysis is based completely on the dollar value of materials and does not consider other important factors.

5. Not Suitable For

ABC analysis is not suitable for small business houses which does not require large volume of inventories. It is also not applicable for materials which cannot be standardized.

6. Possibility Of Loss

It gives less attention to B and C grouped materials. Therefore, there is a chance of loss because of over stock, damage and wastage of these items.

Pros And Cons Of ABC Analysis In Short:

Pros:

- It ensures better control of inventory by minimizing wastage and improper use of materials

- It is suitable for big manufacturing companies

- It improves stock turnover ratio

- It saves time and cost to store materials

- Because of effective control and proper utilization of materials, reduction in time and cost, it helps to improve the profitability of the business.

Cons:

- It is complex than other techniques of inventory control

- It lacks dynamism and flexibility

- It is not suitable for small firms because it consumes high resources

- It ignores GAAP

What Is Responsibility Accounting ?

Responsibility accounting means identifying different responsibility centers (branch, department, units etc.) in the organization and measuring their inputs and output in order to understand their performance. It is an internal accounting system that compares actual performance of different responsibility centers with budget. It helps the company to achieve the accounting objectives.

Benefits Or Advantages Of Responsibility Accounting

The major advantages of responsibility can be highlighted as follows:

1. It Promotes Decentralization

In responsibility accounting, whole organization is divided into different units such as production department, marketing department, maintenance department etc. and responsibility is assigned to departmental managers. So, it encourages decentralization and delegation of responsibility which helps to manage organizational tasks efficiently.

2. It Reduces The Burden Of Top Manager

This system assigns the responsibility and duties to the managers of different departments, units, or responsibility centers. So, it reduces the workload of top managers and they can use their time and effort to make future plans and policies.

3. Fair Performance Evaluation

It evaluates the performance or achievement of  departments or units with the help of pre-established standards. It helps to measure the efficiency of each manager and employee of different responsibility centers. 

4. It Increases Motivation

Lower level managers know that they are under supervision and their achievement will be compared with pre-planned goals. So, it create awareness and motivates them to perform better to obtain good results.

5. Better Decision Making

Responsibility accounting provides data and information about the performance and outcomes of each department to the top level management. It helps the managers to make important decision regarding future planning and actions.

6. Corrective Action

It provides performance report of each responsibility center to the management as quickly as possible. It helps to take appropriate steps and corrective actions to improve operating activities in the organization.

7. Helpful For Cost Control

Responsibility centers are encouraged to perform activities within the limits of budget. It helps to minimize unnecessary costs in the workplace.

8. Suitable For Big Organizations

It is suitable for big business organizations with various departments, segments, units etc. because they cannot be monitored, controlled and managed by a single management.

Drawbacks Or Disadvantages Of Responsibility Accounting

The major disadvantages of responsibility accounting can be pointed out as follows:

1. It Is A Costly System Of Accounting

As we know that this system promotes decentralization, it requires skilled and competent line managers to manage departments properly. So, it requires more cost to hire capable managers and personnel.

2. Possibility Of Employee Frustration

Because of strict supervision and control, employees may feel frustrated and stressed. Frustration and depression adversely affect their performance which may reduce productivity and profitability.

3. Only For Controllable Costs

Responsibility accounting is applicable to measure and control controllable costs only. It does not work with uncontrollable costs.

4. May Lack Accuracy

Results obtained from responsibility accounting may lack accuracy if there is no quick and effective reporting system in the organization. Delayed report makes top management difficult to measure the performance and take appropriate steps in case of any mistake. 

5. It Is A Complex System

It is very difficult to establish organizational chart and to assign authority and responsibility properly to the right person. It is hard task to set goals or objectives for each center. So, it is a complex method of accounting.

6. Not Suitable For Small Organizations

Responsibility accounting is complex and costly system. So, it is not suitable for small business organizations with less operational activities and fewer resources.

Pros:

- It is helpful for performance evaluation of each department.

- It helps the management to make future plans and to make sound decisions

- It helps to minimize unnecessary expenses

- It is suitable for big companies 

- Because of decentralization, it minimizes the load of top management

- It improves the morale of the departmental heads because they can develop managerial skills

Cons:

- It is costly as well as complex system, so responsibility accounting is not applicable for small companies having limited resources

- Subordinates may be frustrated because of strict supervision and control . So, there is a possibility of conflict between individual goals and organizational goals.

- It only works for controllable costs

- It is difficult to define responsibility centers

Benefits Or Advantages Of Leasing

The main advantages of leasing can be described as follows:

1. It Promotes Entrepreneurship

2. It Enhances Liquidity

Leasing saves huge amount of fund which increases liquidity of the firm. Saved fund can be used to fulfill working capital requirement or can be invested in other profitable activities.

3. It Provides Tax Benefit

A company can enjoy tax benefit because lease rental payments are operating expenses and deducted from taxable income. So, leasing saves costs.

4. Convenience Method Of Financing

Leasing is cheaper and convenience than other sources of financing. It does not require various steps and formalities like borrowing loan from banks and financial companies.

5. Suitable For Small And New Business

Leasing is beneficial for small and newly established business firms because it helps to acquire assets without huge capital expenditure and formalities.

6. Provides Protection Against Obsolescence

Another advantage of leasing is that it avoids the risk of obsolescence. Lease agreement is beneficial for lessee (user of asset) because he does not need to bear the risk of obsolescence during the leasing period.

7. Flexible Source Of Financing

Lease rentals and period can be structured, changed or terminated with the mutual understanding between lessor and lessee. So, it is flexible than other sources of long term financing.

8. Not Affected By Inflation

Another notable advantage of leasing is that lease rental is not affected by inflation. Lessee pays same amount of rental payments till the end of the agreement.

Drawbacks Or Disadvantages Of Leasing

Some of the major disadvantages of leasing can be described as follows:

1. Decreases The Return On Equity

Lease rental is deducted from the net income of the company. So, it reduces return on the equity shares.

    

       Also Read: 

Advantages And Disadvantages Of Hire Purchase

Features Of Leasing

2. No Ownership

Leasing does not provide ownership of asset to the user (lessee). Such assets cannot be pledge to obtain loan from banks and financial institutions.

3. It May Increase Cost

Although lessee is not a owner of the asset, he is responsible for repairing and maintenance . So, it increases the cost for the company.

4. No Alteration

Another disadvantages of leasing is, user cannot alter the asset in any situation. If the asset is bought, a company can modify it or make changes to improve its efficiency. But in case of , assets should not be altered by user.

Pros And Cons Of Leasing In Short

Pros:

- It helps to improve the liquidity of the firm

- It is a convenience, flexible and cheaper method of long term financing

- It saves costs because lease rentals are tax deductible

-  It saves the lesser from the risk of obsolescence

Cons:

- It reduces the return of equity shareholders

- It is costlier than debt financing

- Ownership of the asset remains with lessor

Merits Or Advantages Of Process Costing

The main advantages of process costing can be highlighted as follows:

1. Simple Method Of Costing

Process costing is very simple method of computing costs of each stage or process of production. Because of homogeneous products, average cost of product can be calculated easily in less time.

2. Periodic Calculation Of Cost

Cost of each process and per unit cost of finished products can be determined periodically at short intervals with less clerical and paper works. 

3. Suitability

Process costing is suitable for standardized products, large scale production, identical or homogeneous products etc.

4. Better Managerial Control

Cost and performance of each process or department can be evaluated regularly at short intervals. With the help of standard costing, management can take appropriate steps to minimize unnecessary costs and wastage. So, process costing facilitates the management for better control.

Manufacturing firms can add or remove process as per their needs and requirements in order to control the cost of production. So, process costing facilitates flexibility in the production process.

Demerits Or Disadvantages Of Process Costing

The main disadvantages of process costing can be highlighted as follows:

1. Historical Value

This costing method uses historical or past cost data. So, it may not provide accurate cost information for better control.

      Also Read:

Advantages And Disadvantages Of Activity Based Costing

Advantages And Disadvantages Of Job Order Costing

Advantages And Disadvantages Of Standard Costing

2. Inaccuracy

There exists a chance of inaccuracy or error while estimating the cost of work in progress or finished goods because it is based on average cost.

3. Unsuitability

Process costing is not suitable for diverse products. It is suitable only for identical products.

4. Difficulty In Average Cost

It is very difficult and complex to find out average cost if the company manufactures more than one type of products.