Businesspersons, both in large-scale and small-scale businesses are constantly looking for capital to finance their operations. Other than owner’s capital (equity), there are a number of institutions offering debts to businesses; financial institutions, microfinance organizations, and government loans are offering loan capital at competitive rates of interests after making a number of considerations.
Financing in business is a continuous exercise which takes place in stages; successful businesspersons recognize the need to manage and control their working and long-term capital (Bill and McKeith, 2009).
When capital is well managed, a company is able to finance its current and long-term liabilities as they fall due. Different entrepreneurs, economists, politicians and business strategists who support classical capital Structure theory, have discouraged businesses from loan financing policies. They are of the opinion that they will have a negative effect on a business; however, debt finance creates good to a firm that danger (Fridson and Fernando 2002). This paper discusses the benefits of the use of debt; it will also look into debt capital implication to equity holders within a company’s capital structure.
Debt can be classified into short term and long-term depts. Short-term debts should be repaid within a period of one year while long-term debts extend for more than one year. In conventional banking system, loans are repaid to the offering company with predetermined rate of interest. The interest rate is an expense to a business and debited in the trading profit and loss account. In the balance sheet, the loan is recognized as either short-term liability (in the case of short-term loans) or long-term liabilities in the case of long-term loans.
Types of debt finances
Although the underlying concept of debt in a business is the same, there are different categories developed pegged with different aspect. In businesses, the loans can be classified as in the following; hire purchase, Mortgage finance, loans, leases finance, borrowing against bills of exchange, trade creditors and debentures. The different categories are molded to meet the need of the market at a particular time (Fridson and Fernando, 2002)
Working capital, debt and taxations implications
In modern fast-moving business climate, a company relying solely on the amount of cash that it can generate internally is not realistic, the business world need business people who are robust and have the capability of snatching every opportunity that comes by. Debt can boost the working capital of a firm, when having positive working capital, and then a firm is able to have finances to take advantage of opportunities created by the market. With an increased business, it follows that the company will be able to generate more revenue, and an increased taxation results. When a company is paying high rate of taxes, government projects are likely to be geared towards the area and thus the company in the end will take the benefits.
Secondly, the company will raise money for investing in capital projects; the law provides that when a company is expanding and having capital deductions, it is given tax relief through the policy of capital deduction, the policy aims at giving company a chance to reduce their tax liability by the amount of capital invested. The result is a company that has a reduced tax liability (Weygand, Kimmel and Kieso, 2010)..
Tax advantage of debt
In corporate finance management, the tax benefits of debt commonly referred to as tax advantage of debt, is the financial gain that accrues to a company from a tax perspective; where the benefits could have been lost if the company had opted for use of equity instead. When calculating for income changeable to tax, the amount of interest paid for loans is a chargeable expense; this mean that the company will enjoy a reduced tax payable than the case of a company that has used owners capital; let us analyze the situation that arises;
Assume two identical company, one using dept capital and another using shareholders capital; its Company A uses dept capital in its operations (the amount of dept is not the entire source of capital for the company, lest assuming that 30% of the capital is dept capital). Company B does not use dept capital then when calculating their taxable income we will have:
Company A taxable income:
- Income before taxation and interest $100
- Less interest expense $10
- Taxable income $90
- Tax payable at 30% $27
- Profit after tax $63
Company B taxable income:
- Income before taxation and interest $100
- Less interest expense $0
- Taxable income $100
- Tax payable at 30% $30
- Profit after tax $70
From the above analysis, it is clear that the company using debt capital will have a reduced tax liability. The augment that is likely to arise from the above hypothetical example is the interest paid to the financing institution is an added expense, as much as this is true the tax net tax benefit will be positive.
It should be remembered that despite the payment of higher taxes, shareholders of the company would require to be paid some dividends for their investments. When paying dividends a company will have to deduct withholding taxes from the dividends before paying the net effect to the shareholder.
Debt capital implication to equity holders
When a company is using borrowed capital, it means that some of its income has been derived from borrowed capital. Gearing ratio is a measure of financial advantage in a firm; it gauges the percentage of owners capital used in production of revenue with the rate of borrowed capital.
It is calculated as follows:
Gearing Ratio = Sum of Borrowings / (sum Borrowings + sum Equity) * 100
the amount of income produced from borrowed capital should be compared with the amount that is produced by owners capital to gauge the gearing ratio of the company. Although the implication of debts cannot affect shareholders directly, the expenses incurred by the company in managing the debts affect them; they feel that the company is considering other parties as priorities before them. This notion if not well explained can lead to friction in a company (Helfert, 1997).
Analysis and discussion
Debt capital has numerous advantages to a business only if it is well managed; when used in a company, it boosts the working capital thus a company can take advantage of available opportunities as they fall due. As much there is an interest to pay on the borrowed capital, if well managed it will have a positive net effect. When taxing a company, international accounting standards have recognized interest paid on borrowed capital as a deductable amount. This reduces the tax burden of a company.
When well managed, debt can be used to boost working capital of a firm; working capital is the operating finances that a company can use at one particular point to take advantage of prevailing condition. It assists in smooth operation of business and provides money to finance current opportunities brought about by the market. Although debt finances increases the gearing ratio of a company, it is important in giving the company a chance to use its liquid cash to finance working capital; operating with positive working capital gives rise to higher chances of success in ones business (Michael, 2006).
The tax benefit resulting from allowable deduction of interest on debt capital, can be used to invest and expand a company. Expansion lead to further tax relieves in the form of investment deductions and allowances, so in the end a company stands to benefit from using debt capital.
The overall effect of debt capital is that it is beneficial to a company and thus the opinion taken by classical capital Structure theory does not hold. What is important to realize and manage is the gearing ratio. It should be managed at an equilibrium rate (Atrill and Jenner, 2009).
Debt is a source of capital for large, medium and small-scale businesses; though when repaying it an interest will be paid, either in form of profit share in Islamic banking or interest in conventional banking, it has a positive net effect on company’s taxes. It reduces the amount of taxable income. Despite the numerous advantages brought about by debt financing, it need to be managed effectively and gearing ratio maintained at an equilibrium level. The standpoint taken by classical capital Structure theory does not hold since there are numerous benefits that a company stands to benefit when using debt capital.
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