Financial Management In

Business
Capitalization In Financial Management

LESSON 2
Content

• Capitalization
• Overcapitalization
• Undercapitalization
• Depreciation
• Theory of Capitalization
• Capitalization of Start Up
• Debt Financing
• Debt Financing for Small Business
What is Capitalization?

• Capitalization comprises of share capital, debentures, loans, & free reserves.

• Capitalization represents permanent investment in companies excluding long-term loans.

Capitalization can be distinguished from Capital Structure.

• Capital Structure is a broad term, and it deals with qualitative aspect of finance.

• Capitalization is an accounting method in which a cost is included in the value of an asset

and expensed over the useful life of that asset, rather than being expensed in the period
the cost was originally incurred.
Why is Capitalization Important in Business?

• To capitalize is to record a cost or expense on the balance sheet for the purposes of
delaying full recognition of the expense.

• In general, capitalizing expenses is beneficial as companies acquiring new assets with

long-term lifespans can amortize or depreciate the costs. This process is known as
Capitalization.
Understanding Capitalization

• Capitalization has two meanings.

• In Finance, capitalization is a quantitative assessment of a firm’s capital structure. Here it

refers to the cost of capital in the form of a corporation’s stock, long-term debts, and
retained earnings.

• In Accounting, capitalization means an accounting rule used to recognize a cash outlay as

an asset on the balance sheet, rather than an expense on the income statement. The
matching principle requires companies to record expenses in the same accounting
period in which the related revenue is incurred.
Understanding Capitalization

• Example of Capitalization in Accounting: Office supplies are generally expensed in the

period when they are incurred since they are expected to be consumed within a short
period of time.

• However, some larger office equipment may provide a benefit to the business over more
than one accounting period. These items are fixed assets, such as computers, cars, and
office buildings.

• The costs of these items are recorded on the general ledger as the historical cost of the
asset. Therefore, these costs are said to be capitalized, not expensed.
Understanding Capitalization
• Capitalized assets are not expensed in full against earnings in the current accounting
period. A company can make a large purchase but expense it over many years,
depending on the type of property, plant, or equipment involved.

• As the assets are used up over time to generate revenue for the company, a portion of the
cost is allocated to each accounting period. This process is known as depreciation (or
amortization for intangible assets).

• For leased equipment, capitalization is the conversion of an operating lease to a capital

lease by classifying the leased asset as a purchased asset, which is included on the
balance sheet as part of the company's assets.
Year No Depreciation Value (15%) Sales Amount
1 $10,000.00 $4,000
2 $8,500.00 $3,500
3 $7,225.00 $1,500
4 $6,141.25 $2,000
Understanding Capitalization

• The Financial Accounting Standards Board (FASB) issued a new Accounting Standards
Update (ASU) in 2016 that requires all leases over twelve months to be both capitalized
as an asset and recorded as a liability on the lessee's books, to fairly present both the
rights and obligations of the lease.

Capitalized Cost vs Expense

• When trying to discern what a capitalized cost is, it’s first important to make the distinction
between what is defined as a cost and an expense in accounting terms.

• A cost on any transaction is the amount of money used in exchange for an asset.

• A company buying a forklift would mark such a purchase as a cost. An expense is a

monetary value leaving the company; this would include something like paying the
electricity bill or rent on a building.
Special Considerations in Capitalization

• Generally, a company will set "capitalization thresholds." Any cash outlay over that
amount will be capitalized if it is appropriate.

• Companies will set their own capitalization threshold because materiality varies by
company size and industry.

• Example, a local mom-and-pop store may have a $500 capitalization threshold, while a
global technology company may set its capitalization threshold at $10,000.

• Financial Statements can be manipulated when a cost is wrongly capitalized or expensed.

If a cost is incorrectly expensed, net income in the current period will be lower than it
otherwise should be. The company will also pay lower taxes in the current period. If a cost
is incorrectly capitalized, net income in the current period will be higher than it otherwise
should be. In addition, assets on the balance sheet will be overstated.
Capitalization in Finance

• Another aspect of capitalization refers to the company’s Capital Structure.

• Capitalization can refer to the book value cost of capital, which is the sum of a company's
long-term debt, stock, and retained earnings.

• The alternative to the book value is the market value. The market value cost of capital
depends on the price of the company's stock. It is calculated by multiplying the price of
the company’s shares by the number of shares outstanding in the market.

• Example, if the total number of shares outstanding is 1 billion and the stock is currently
priced at $10, the market capitalization is $10 billion. Companies with a high market
capitalization are referred to as large caps (more than $10 billion); companies with
medium market capitalization are referred to as mid caps ($2 - $10 billion); and
companies with small capitalization are referred to as small caps ($250 million - $2
billion).
Capitalization in Finance

• It is possible for a company to be overcapitalized or undercapitalized.

• Overcapitalization occurs when earnings are not enough to cover the cost of capital,
such as interest payments to bondholders or dividend payments to shareholders.

• Undercapitalization occurs when there's no need for outside capital because profits are
high, and earnings were underestimated.

Overcapitalization: Undercapitalization:
Earnings < Capital Earnings > Capital
Overcapitalization

• Overcapitalization is a situation in which actual profits of a company are not sufficient

enough to pay interest on debentures, on loans and pay dividends on shares over a
period of time.

• This situation arises when the company raises more capital than required. A part of capital
always remains idle. With a result, the rate of return shows a declining trend. The causes
can be:

1. High Promotion Cost

• When a company goes for high promotional expenditure, i.e., making contracts,
canvassing, underwriting commission, drafting of documents, etc. and the actual
returns are not adequate in proportion to high expenses, the company is over-
capitalized in such cases.
 Overcapitalization

2. Purchase of Assets at Higher Prices

• When a company purchases assets at an inflated rate, the result is that the book
value of assets is more than the actual returns. This situation gives rise to over-
capitalization of company.

3. A Company’s Floatation in Boom Period

• At times company must secure its solvency and thereby float in boom periods.

• That is the time when rate of returns are less as compared to capital employed. This
results in actual earnings lowering down and earnings per share declining.

*A boom refers to a period of increased commercial activity within either a business, market, industry, or an economy.
Overcapitalization

4. Inadequate Provision for Depreciation

• If the finance manager is unable to provide an adequate rate of depreciation, the
result is that inadequate funds are available when the assets need to be replaced or
when they become obsolete.

• New assets will then be purchased at high prices which prove to be expensive.

5. Liberal Dividend Policy

• When the directors of a company liberally divide the dividends into the shareholders,
the result is inadequate retained profits which are very essential for high earnings of
the company.

• The result is deficiency in company. To fill up the deficiency, fresh capital is raised
which proves to be a costlier affair and leaves the company to be over- capitalized.
Overcapitalization

6. Over-Estimation of Earnings
• When the promoters of the company overestimate the earnings due to inadequate
financial planning, the result is that company goes for borrowings which cannot be
easily met, and capital is not profitably invested.

• This results in consequent decrease in earnings per share.

Effects of Overcapitalization

Effect on Shareholders
• Since the profitability decreases, the rate of earning of shareholders also decreases.
• The market price of shares goes down because of low profitability.
• The profitability going down influences the shareholders by making their earnings become
uncertain.
• With the decline in goodwill of the company, share prices decline. As a result, shares
cannot be marketed in capital market.
Effects of Overcapitalization

Effect on a Company
• Because of low profitability, reputation of company is lowered.
• The company’s shares cannot be easily marketed.
• With the decline of earnings of company, goodwill of the company declines, and the result
is fresh borrowings are difficult to be made because of loss of credibility.
• In order to retain the company’s image, the company indulges in malpractices like
manipulation of accounts to show high earnings.
• The company cuts down it’s expenditure such as on maintenance, replacement of assets,
adequate depreciation.
Effects of Overcapitalization

Effect on the Public

• In order to cover up their earning capacity, the management indulges in tactics like
increase in prices or decrease in quality.
• Return on capital employed is low. This gives an impression to the public that their
financial resources are not utilized properly.
• Low earnings of the company affects the credibility of the company as the company is not
able to pay its creditors on time.
• It also influences working conditions and payment of wages and salaries also reduces.
Undercapitalization

• An undercapitalized company is one which incurs exceptionally high profits as

compared to industry. An undercapitalized company situation arises when the estimated
earnings are very low as compared to actual profits.

• This gives rise to additional funds, additional profits, high goodwill, high earnings and thus
the return on capital shows an increasing trend. The causes can be:

• Low promotion costs

• Purchase of assets at deflated rates
• Conservative dividend policy
• Floatation of company in depression stage
• High efficiency of directors
• Adequate provision of depreciation
• Large secret reserves are maintained
Effects of Undercapitalization

Effect on Shareholders
• Company’s profitability increases. As a result, rate of earnings go up.
• Market value of share rises.
• Financial reputation also increases.
• Shareholders can expect a high dividend.

Effect on a Company
• With greater earnings, reputation becomes strong.
• Higher rate of earnings attract competition in market.
• Demand of workers may rise because of high profits.
• The high profitability situation affects consumer interest as they think that the company is
overcharging on products.
Effects of Undercapitalization

Effect on the Public

• With high earnings, high profitability, high market price of shares, there can be unhealthy
speculation in stock market.
• ‘Restlessness in general public is developed as they link high profits with high prices of
product.
• Secret reserves are maintained by the company which can result in paying lower taxes to
government.
• The general public inculcates high expectations of these companies as these companies
can import innovations, high technology and thereby best quality of product.
Overvaluation

• Market Capitalization reflects the perceptions of investors. The true value of a company,
however, may differ from its market capitalization. In various times throughout history,
market crashes came about as a result of the over-speculation of investors.

• Speculation is the buying of certain investments that increase in value. This, in turn,
drives other investors to speculate, as they too wish to cash in on the surge in market
value. Such behavior often leads to a crash when they realize that a company's market
capitalization does not reflect the business's true value.

• A company's ability to make profits is a result of the amount of economic capital under its
ownership. An increase in capital leads to business expansion. An increase in capital
leads to an increase in total assets. Assets, which make up a business's equity, is the true
method of valuation used by financial accountants, not financial speculators and
investors.
Understanding How to Capitalize

• One of the most important principles of accounting is the matching principle.

• The matching principle states that expenses should be recorded for the period incurred
regardless of when payment (e.g., cash) is made.

• Recognizing expenses in the period incurred allows businesses to identify amounts spent
to generate revenue. For assets that are immediately consumed, this process is simple
and sensible.

• However, large assets that provide a future economic benefit present a different
opportunity.
Understanding How to Capitalize

• Example, a company purchases a delivery truck for daily operations. The truck is
expected to provide value over a period of 12 years.

• Instead of expensing the entire cost of the truck when purchased, accounting rules allow
companies to write off the cost of the asset over its useful life (12 years).

• In other words, the asset is written off as it is used. Most companies have an asset
threshold, in which assets valued over a certain amount are automatically treated as
a capitalized asset.
Depreciation

• The process of writing off an asset over its useful life is referred to as depreciation,
which is used for fixed assets, such as equipment. Amortization is used for intangible
assets, such as intellectual property. Depreciation deducts a certain value from the asset
every year until the full value of the asset is written off the balance sheet.

Income Statement
• Depreciation is an expense recorded on the income statement; it is not to be confused
with “accumulated depreciation," which is a balance sheet contra account. The income
statement depreciation expense is the amount of depreciation expensed for the period
indicated on the income statement.

• The accumulated depreciation balance sheet contra account is the cumulative total of
depreciation expense recorded on the income statements from the asset's acquisition
until the time indicated on the balance sheet.
Example of Accumulated Depreciation Value

A company bought a piece of equipment for $500,000 and

estimated its useful life to be 10 years with a yearly depreciation
expense of $50,000.

Year No. Depreciation Value Formula

1 $50,000
2 $100,000 Year 1+ Year 2
3 $150,000 Year 2+ Year 3
4 $200,000 Year 3+Year 4
5 $250,000 Year 4+ Year 5
Depreciation

Leased Equipment
• For leased equipment, capitalization is the conversion of an operating lease to a capital
lease by classifying the leased asset as a purchased asset, which is recorded on the
balance sheet as part of the company's assets.

• The value of the asset that will be assigned is either its fair market value or the present
value of the lease payments, whichever is less.

• Also, the amount of principal owed is recorded as a liability on the balance sheet.
Theories of Capitalization

• The problems of determining the amount of capitalization is necessary both for a newly
started company as well as for an established concern.

• In case of the new enterprise, the problem is more severe in so far as it requires the
reasonable provision for future as well as for current needs and there arises the danger of
either raising excessive or insufficient capital.

• But the case is different with established concerns.

• They must revise or modify their financial plan either by issuing of fresh securities or by
reducing the capital and making it in conformity with the needs of the enterprises.
However, to estimate the amount of capitalization two theories have been pronounced.
Cost Theory of Capitalization

• Under this theory, the capitalization of a company is determined by adding the initial
actual expenses to be incurred in setting up a business enterprise as a going concern.

• It is aggregate of the cost of fixed assets (plant, machinery, building, furniture, goodwill,
and the like), the amount of working capital (investments, cash, inventories, receivables)
required to run the business, and the cost of promoting, organizing and establishing the
business.

• In other works, the original total outlay incurred on various items becomes the basis for
determining the capitalization of a company.
Cost Theory of Capitalization

• If the funds raised are sufficient to meet the initial costs and day to day expenses, the
company is said to be adequately capitalized.

• This theory is very helpful for the new companies as it facilitates the calculation of the
amount of funds to be raised initially.

• Cost theory, no doubt, gives a concrete idea to determine the magnitude of capitalization,
but it fails to provide the basis for assessing the net worth of the business in real terms.

• The capitalization determined under this theory does not change with earnings.
Cost Theory of Capitalization

• Moreover, it does not consider the future needs of the business.

• This theory is not applicable to the existing concerns because it does not suggest whether
the capital invested justifies the earnings or not. Moreover, the cost estimates are made at
a particular period.

• They do not consider the price level changes. For example, if some of the assets may be
purchased at inflated prices, and some assets may remain idle or may not be fully utilized,
earnings will be low and the company will not be able to pay a fair return on the capital
invested. The result will be over-capitalization.

• In order to do away with these difficulties and arrive at a correct figure of capitalization,
‘earnings approach’ is used.
Earnings Theory of Capitalization

• This theory assumes that an enterprise is expected to make profit. According to it, its true
value depends upon the company’s earnings and/or earning capacity.

• Thus, the capitalization of the company or its value is equal to the capitalized value of its
estimated earnings.

• To find out this value, a company, while estimating its initial capital needs, must prepare a
projected profit and loss account to complete the picture of earnings or to make a sales
forecast.

• Having arrived at the estimated earnings figures, the financial manager will compare with
the actual earnings of other companies of similar size and business with necessary
adjustments.
Earnings Theory of Capitalization

• After this the rate at which other companies in the same industry, similarly, situated are
making earnings on their capital will be studied.

• This rate is then applied to the company’s estimated earnings for determining its
capitalization.

• Under the earnings theory of capitalization, two factors are generally considered to
determine capitalization:

• How much the business can earn

• What is the fair rate of return for capital invested in the enterprise.

• This rate of return is also known as ‘multiplier’ which is 100 per cent divided by the
appropriate rate of return.
Earnings Theory of Capitalization

• Example, if a company can make net profit of $30,000 annually and the rate of earnings is
10%, the capitalization of the company will be $3,00,000 (i.e. 30,000 x 100/ 10). But if the
total investment during that period in the whole industry is $10 Million and the total
earnings of the industry rate $1.5 Million, the earning capacity of the industry are thus
15%.

• But business under consideration is earning 10% only. This is a case of over capitalization
as the earnings of $30,000 justify investment of $200,000, only $30,000 X 100/15) in view
of earning capacity of the industry. Hence, the company is over-capitalized to the tune of
$100,000.
Earnings Theory of Capitalization

• Though earning theory is more appropriate for going concerns, it is difficult to calculate
the amount of capitalization under this theory.

• It is based upon a ‘rate’ by which earnings are capitalized. This rate is difficult to estimate
in so far as it is determined by a number of factors not capable of being calculated
quantitatively.

• These factors include nature of industry/ financial risks, competition prevailing in the
industry and so on. New companies cannot depend upon this theory as it is difficult to
estimate the expected returns in their case.

• As regards capitalization, it is often said that “a concern should neither be overcapitalized,

nor under-capitalized, the aim should be to achieve fair capitalization”.
Capitalization in a Start-up

• The word "capitalization" can have many meanings in small business.

• It's used in accounting to describe the cost of equipment that's written off as depreciation
over time. It also describes the conversion of retained earnings into capital and the
conversion of an operating lease into a capital lease.

• In this case, though, capitalization refers to generating the money that allows a business
to open its doors. It's also called funding, backing, capital investment, and owner's stake.

• How a start-up is capitalized can influence the company’s success in long term. Funding
start-up expenses, inventory, and operations is a challenge for many business owners. It's
important to understand and explore the options available to entrepreneurs, along with
each method's risks and rewards.
Capitalization in a Start-up

• Capitalization is the initial investment or seed money for a start-up, and it's usually the
investment that the business owner and any other investors make in the firm.

• Combined with operating cash flows, it enables start-ups to begin, continue operations
and grow the firm by:

• Paying for assets such as equipment, vehicles, and real estate

• Funding growth by purchasing inventory, hiring employees, financing receivables, and
more
• Providing reserves for the inevitable rainy days

• Capitalization can include both equity and debt, although companies typically prefer
to keep debt to a minimum
Equity & Debt Funding

• Two types of capitalization exist, called equity funding and debt funding.

• Work with business mentors and tax and accounting professionals to determine the right
mix of equity and debt capitalization that makes sense for the startup.

• Equity means ownership, which could be in stock or shares, partnership interests; or if an

LLC, equity is issued in the form of interests.

• The advantages of equity include no monthly payments and no one looking for immediate
repayment of their investment.
Equity & Debt Funding

• Some equity investors may even be experts in a field and be able to offer useful business
advice.

• The downside of equity is the owner is no longer in complete control of the business
because they've given a certain proportion of their ownership equity in exchange for
funds.

• In some cases, equity investors may also be entitled to a portion of profits.

• Debt is a loan issued to a company. The advantages include allowing the owner to
maintain ownership control, and the regular timely repayment of the loan builds business
credit.

• Additionally, the owner can deduct interest payments on their business income tax return.
Debt Financing

• Debt financing is when money is borrowed to run a business, as opposed to equity

financing, in which money is raised from investors who are in return entitled to a share of
the profits from the business.

• There are 2 types of debt financing, long term and short term. Debt financing is also
known as equity financing. Types of debt or equity financing:

• Personal loans
• Lines of credit
• Loans from family or friends
• Credit cards
• Government loans
• Equipment loans
• Peer-to-peer loans
• Real estate loans
• Home equity loans
Debt Financing

Long-Term Debt Financing

• Long-term debt financing generally applies to assets a business is purchasing, such as
equipment, buildings, land, or machinery. A lender will normally require that long-term
loans be secured by the assets to be purchased.

• With long-term debt financing, the scheduled repayment of the loan and the estimated
useful life of the assets often extends for three- to seven-year terms.

• Long-term debt will most likely have fixed interest rates that convert into consistent
monthly payments and high predictability.

• Note: Long-term debt financing makes it easier for businesses to budget, make consistent
payments each month, and increase their credit score.
Debt Financing

Short-Term Debt Financing

• Short-term debt financing usually applies to money needed for the day-to-day operations
of the business, such as purchasing inventory, supplies, or paying the wages of
employees.

• Short-term financing is referred to as an operating loan or a short-term loan because

scheduled repayment takes place in less than one year.

• Short-term financing is commonly used by businesses that tend to have temporary cash
flow issues when sales revenues are insufficient to cover current expenses. Startup
businesses are particularly prone to cash flow management problems.

• Credit cards are a popular source of short-term financing for small businesses. Other
common types of short-term debt financing include short-term bank loans, accounts
payable, wages, lease payments, and income taxes payable
Advantages of Debt Financing

• The main advantage of debt financing over equity financing is that the lender does not
take an equity position in a business. The owner retains full ownership, and the lender
has no control over the running of the business.

• Debt interest costs are fully tax-deductible as a business expense, and in the case of
long-term financing, the repayment period can be extended over many years, reducing
the monthly expense. Assuming the loan does not have a variable rate, the interest
expense is a known quantity for budgeting and business planning purposes. Other
advantages include:

• Builds up business credit

• Provides leverage for owners' equity
• Gives stability in budgeting and planning for future
• Long-term debt can eliminate reliance on more expensive short-term options
Disadvantages of Debt Financing

• For extended financing, banks normally require assets of the business to be posted as
collateral for the loan.

• If (as is common with small businesses) the business does not have sufficient collateral,
the lender will require personal guarantees from the business owners.

• This leaves the owners personally responsible for paying back the loan, even if their
business is incorporated.

• If the business is unable to make the loan payments, whatever personal assets posted as
collateral, such as house, car, investment accounts, can be seized by the bank.
Disadvantages of Debt Financing

• With debt financing, the fixed repayment schedule and the high cost of loan repayment
can make it difficult for a business to expand.

• With equity financing, money is invested in the business in exchange for equity. There is
no fixed repayment schedule, and investors generally have a long-term goal of return on
investment.

• If a business needs debt financing or equity investment, it must have a solid business
plan in place before any lender or investor will consider giving funding.

• This includes the financial details of a business, such as an income statement, cash flow
projections, and a balance sheet.
Debt Financing for Short-Term Working Capital Needs

Types of short-term business financing:

• Trade Credit
• Short-term Loan
• Business Line of Credit
• Factoring
• Merchant Cash Advance

Trade Credit
• A type of debt financing where the business seeks credit from other businesses who
serve as their suppliers.

• The supplier usually extends terms to a business such as 2/10, net 30. This means that
the business will get a 2% discount if paid in 10 days, otherwise, the balance is due in 30
days.
Debt Financing for Short-Term Working Capital Needs

Short-Term Loan
• Business loans that have a maturity of one year or less. This means that they must be
repaid to the lender during that time.

• Small businesses more often need short-term as opposed to long-term business loans.

• Term loans with short maturities can help a business owner meet an immediate need for
financing without requiring making a long-term commitment.
Debt Financing for Short-Term Working Capital Needs

Business Line of Credit

• Business Line of Credit gives the business continuous access to cash when needed. The
business line of credit is generally unsecured by collateral and has favorable interest
rates.

• For a business to obtain an unsecured business line of credit with favorable terms, it must
have an excellent credit record.

• Usually, an unsecured business line of credit is obtained from a commercial bank and is
designed to meet quick cash needs. No monthly payment is due until the business taps
into the line of credit.
Debt Financing for Short-Term Working Capital Needs

Factoring
• Uses a company's accounts receivables to raise cash for short-term needs.

• Accounts receivable factoring is used when a business cannot qualify for a short-term
business loan or unsecured business line of credit.

• Factoring is when a business sells its uncollected invoices to a third-party, which is called
a factor, at a discount in order to raise money.
Debt Financing for Short-Term Working Capital Needs

Merchant Cash Advance

• Uses a business's credit card receipts as a type of collateral in order to make loans like
paycheck cash advances for individuals.

• Merchant cash advances are generally only available to businesses that have a steady
flow of credit card receipts.

• The interest rates are higher than for short-term bank loans and are more in the range of
factoring. The maturity of the loans is very short-term.
Short Term Vs Long Term Interest Rates

• In a normal economy, interest rates on short-term loans are lower than interest rates on
long-term loans.

• In a recessionary economy, however, short-term loan rates may be higher than long-term
loan rates.

• A graphical representation of interest rates based on time and percentage is called the
yield curve.

• Short-term loan rates are usually based on the prime interest rate plus some
premium.The bank or other lender determines the premium by determining what risk the
company is to them.
When to Use Debt Financing

High-Growth Businesses
• For fast-growing companies, it may be more optimal to consider debt financing instead of
equity financing.

• Fast-growing companies need increasing amounts of capital injected.

• Debt financing is less expensive than equity financing since the interest payments that
businesses make on debt is tax-deductible.

• For debt financing to be viable, the business must generate enough cash flow to make its
interest payments on the debt financing.
When to Use Debt Financing

Short-Term Financing Needs

• Another situation in which companies should use debt instead of equity financing is for
their short-term financing needs.

• Short-term debt financing usually matures in less than one year and is used to finance a
firm's working capital needs such as its investment in accounts receivable and inventory.
Advantages of Debt Financing

Tax Deductibility of Interest Payments

• The interest payments on debt financing are counted as an expense and are tax-
deductible. Example, if a business marginal tax rate is 30%, then the amount of the
interest payments shields that amount of income.

Management Control
• Business owners become obligated to make the agreed-upon payments on time when
they borrow from the bank or another lender, but that's the end of their obligation. They
retain the right to run the business, however they choose without outside interference
from private investors.

Lower Interest Rate

• Equity financing can be more expensive than debt financing. The interest rate on a bank
loan or other forms of debt financing will be less than the cost of equity due to the tax-
deductibility of interest payments.
Advantages of Debt Financing

Accessibility
• Debt financing is more accessible to small businesses than equity financing. Example,
only 0.07% of small businesses ever access the venture capital market in search of equity
financing. The rest of the small businesses tend to rely heavily on debt financing.

Business Credit Score

• Businesses can improve their business credit score by showing credit worthiness in
handling their debt, such as always making payments on time.

No Profit Sharing
• If the business uses debt financing, there is no profit sharing because there are no
investors. The owner of the business can keep the profit and distribute it as needed.
Disadvantages of Debt Financing
Repayment
• If a business uses debt financing and borrows money, it must repay principal and interest
regardless of their cash flow situation. If the business shutters, the debt still must still be
paid.

• Lenders will have a claim for repayment before any equity investors if the owners are
forced into bankruptcy.

Cash Flow
• Too much reliance on debt financing will cause a business to have a lower cash flow
since principal and interest payments must be made on the debt.

• To measure reliance on debt financing as opposed to equity financing, a business can

calculate its debt-to-equity ratio. The lower the ratio, the better. Low or negative cash flow
is one of the biggest problems small businesses normally face.
Disadvantages of Debt Financing

Collateral
• Many small businesses may have to put up collateral in order to get debt financing.

• Many business owners balk at collateral because they often have to use assets they own
privately, like their homes.

Credit Rating
• It might seem attractive to keep bringing on debt when a firm needs money, a practice
knowing as “leveraging up“, but each loan will be noted on a credit report and will affect
credit rating.

• The more money is borrowed, the higher the risk becomes to the lender, so there will be a
higher interest rate on each subsequent loan.
Disadvantages of Debt Financing

Here are some alternatives to consider when debt financing may not be viable:

Mezzanine Financing
• This alternative to debt financing is a high-interest, unsecured financing option that
provides investors the opportunity to convert debt to equity, specifically shares in the firm
if the company defaults on the loan.

Hybrid Financing
• Companies may use a combination of debt and equity financing in proportions that will
minimize their weighted average cost of capital.
Disadvantages of Debt Financing

Crowdfunding
• Small businesses sometimes try their hand at fundraising on one of the crowdfunding
platforms on the internet.

Credit Card Financing

• Credit cards can be used to finance a company, although business owners would pay a
high-interest rate and be subject to strict repayment terms.

• The viability of using credit card sources also depends on credit history and the amount of
financing needed.

Savings
• Money from savings and family and friends is called internal equity financing.
Q&A Session