Businesses can obtain capital for long-term operations from debt, equity, or hybrid financing options. Notably, each of the options mentioned above has unique characteristics, which are either desirable or undesirable to a business. As a result, organizational managers should collaborate in strategic financial planning to choose a financing option that meets a company’s current and future financial requirements. Equity financing entails a situation in which a business allows the public to own it by selling its shares to the public. Contrastingly, debt financing refers to borrowing money from a company from financial institutions for later repayment. There are several advantages and disadvantages associated with debt, equity, and hybrid financing options, that financial managers should consider during financial decision-making.
Debt Financing: Bonds and, Their Advantages to a Business
Sometimes companies can decide on financing their long-term projects by issuing corporate bonds to public members to receive working capital. Notably, corporate bonds as a long-term financing method have some unique advantages over bank loans, making bonds more preferable. The flexibility of bonds in security requirements provides managers with choices on whether to finance a company’s operations using secured or unsecured bonds. Bonds also offer an economically stable source of debt because interests on bonds remain fixed despite changes in the economy (Wright, 2017). Unlike the issuance of additional shares, which further dilutes the company’s ownership, bondholders are creditors and no other company owners. Notably, bonds enable companies to acquire debts over long periods as their redemption can take several years.
In as much as bonds are uniquely advantageous to finance long-term projects of a company, they also present numerous disadvantages. For instance, bond financing obliges companies to pay common interests to bondholders regardless of the general financial performance of the business. In addition, bonds expose the business to the risk of a decrease in the value of their shares because companies should pay interest on bonds before paying dividends to ordinary shareholders (Wright, 2017). Notably, bondholders have contractual powers to restrict businesses from investing their funds in high-risk ventures. Unlike bank financing options, bond financing limits companies from enjoying waivers and other beneficial contractual changes. Financing through issuing corporate bonds may be time and money-consuming, where a company needs to build a good credit history to acquire finances through bonds successfully.
Bank Loans and Their Advantages
Additionally, bank loans provide another option of debt financing where companies can get long-term capital. Like bonds, equity, and hybrid financing options, bank loans are preferable due to their numerous advantages. For instance, bank loans foster the fast growth of businesses with little capital by increasing their investment power at the right time. Therefore, small and medium enterprises can use bank loans to tap into current profitable opportunities, which are difficult for other businesses (Ahmed, 2019). Unlike equity financing, bank loans give the business tax advantage, as interests on loans are tax-deductible. Unlike dividends payable to shareholders that increase as profits of a company increase, interest rates agreed upon between the bank and the borrower and the amount borrowed remained the same regardless of the company’s profitability (Zheng, 2018). In addition, banks do not demand a portion of ownership of the business for the loans they provide to companies (Obuya, 2017). As a result, owners enjoy all future business profits and retain control and ownership of the business.
Even if bank loans are more advantageous than equity and hybrid financing, they present several limitations that, the management should consider before deciding to adopt a long-term finance option. One of the drawbacks of a bank loan is that it requires the borrower to have an excellent credit history to qualify for a long-term loan (Ahmed, 2019). It may take long before the borrower attains the required credit ratings. Noteworthy, bank loans are undesirable for start-up businesses and upcoming investors, as it requires one to have collateral against the loan they wish to borrow (Chadha and Sharma, 2016). Notably, collateral can be either valuable business assets or personal assets of the borrowers, which the money lending institution holds the right to possess if the borrower defaults in loan repayment (Lai and Shad, 2017). This requirement can limit access to long-term loans for young upcoming businesses, as most do not have valuable properties to place as collateral (Wright, 2017). Even if a company can afford to provide collateral to secure a loan, there is a high risk of a business suffering bankruptcy in case of inability to pay the loan.
Advantages of Ordinary Shares in Equity Financing
Ordinary shares provide the cheapest business finance option because the money from the sale of shares does not attract interest and other financial costs compared to debt financing. Sourcing finances from the sale of ordinary shares does not require a business to prove its creditworthiness or provide collateral to obtain money. Since the issuance of common shares increases the company’s ownership, there are high chances that apart from providing financial assistance, the ordinary shareholders will give valuable advice and ensure improved business decision-making for the growth of a business. Notably, shareholders’ main interests lie in their investment in the industry and, they will always ensure that the company makes strategically informed decisions that consider their welfare (Shoemaker et al., 2020). Issuing ordinary shares creates high possibilities for a business to grow as shareholders can contribute additional intangible benefits, such as skills, experience, and contacts.
Ordinary shares as a source of long-term capital present numerous limitations to a company. For instance, obtaining money from common shares requires a business to sacrifice its ownership and autonomy in decision-making and control. Therefore, the original business owners cannot make business decisions without involving ordinary shareholders. Mostly, common shareholders investors require companies to allow them to own a substantial portion of the business. This percentage of ownership gives ordinary shareholders more power than owners in cases where companies are new or do not have a robust financial foundation (Shoemaker et al., 2020). For these reasons, many start-ups and financially weak businesses find equity financing quite challenging to adopt. In addition, obtaining capital from ordinary shares is costly because dividends payable to common shareholders are non-tax-deductible. Unlike preference shares, dividends on ordinary shares increase with the company’s profitability (Sassi, 2019). In addition, financing through common shares consumes a company’s time and resources, which may delay the achievement of the main goals of the business.
Advantages of Preference Shares
In addition to pure debt and equity financing, companies can finance their long-term operations through preferential shares if they want to enjoy the benefits of both equity and debt financing in a single financing option. Preference shares as a source of long-term capital provide a business with numerous benefits (Sassi, 2019). For instance, preferential shares do not oblige a company to pay dividends to their holders because their issuance does not result in a compulsory liability. In addition, preferential shares help companies improve their capital borrowing capacity by reducing the debt ratio’s equity to debt ratio. Unlike ordinary shareholders, preferential shareholders invest intending to receive fixed dividends but not controlling or claiming a company’s ownership. Similar to common shares, preference shares provide capital to companies without imposing collateral requirements.
On the downside, financing business operations through preference shares presents numerous disadvantages to a business. For instance, preference shares are costlier than debt or equity options. The interests on dividends payable to preferential shareholders have tax obligations and are paid out of a company’s net profits. Although companies are not legally obliged to pay dividends to preferential shareholders, default in their payment can ruin the credit reputation of a company (Sassi, 2019). During liquidation, companies must settle the debts from preferential shareholders before paying ordinary shareholders even if both shareholders enjoy similar benefits at usual times. Therefore, hybrid financing may be preferable when a company wants to blend the advantageous and disadvantageous qualities of both debt and equity financing.
In conclusion, ordinary shares, preference, bank loans, and bonds constitute the leading equity and debt financing options for companies. The choice to source long-term capital from either of the options mentioned above depends on the qualities of financing that companies find desirable. For instance, a company that wishes to increase its ownership share its control can source long-term capital by issuing ordinary shares to the public. However, if a company wants to acquire more long-term wealth from the crowd without diluting its ownership, it can do so by issuing preference shares. In addition, businesses with reputable creditworthiness can obtain substantial long-term capital from bank loans and the issuance of bonds to the public.
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