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