5 reasons Why the Debt is Good for Your Business
Debt often has a negative connotation. Debt represents an increase in risk, a lack of cash flow, and an inability to settle liabilities. On the other hand, most companies have some level of debt.
Debt generates growth and drives the economy. As long as the debt is properly managed, it can be beneficial for businesses. Below we state why the debt is good for doing business:
1.) Debt supports business growth
One of the main ways to increase your business volume is to fund debt. At a time when you have the opportunity to increase the volume of business and do not have enough funds to independently finance growth, the debt can be of considerable benefit. In the case where the cost of the missed opportunity is higher than the cost of debt then it is desirable to reach for the debt and create value by its activity.
2.) Debt is cheaper than capital
Debt is a cheaper form of capital financing (principal). In fact, debt is less risky because it is paid before the dividend. The Company has no legal obligation to pay dividends while it has a liability to pay off the principal and interest. Most often, the debt is secured by another type of asset until the capital is secured and paid out after all other stakeholders (suppliers, employees, creditors, the state). In the event of bankruptcy, owners are the last to charge. The investor (owner) wants to be compensated for the risk he is bearing. For this reason, demanding return on capital is higher than the cost of debt.
3.) Debt builds credibility and maintains discipline
Debt helps you build relationships with financial institutions. It will be much easier for you to borrow money when they see someone loan you back in the past and when you have proven the discipline of settling the obligation. Managers behave more responsibly and are less inclined to take risk ventures when under debt. Realizing that their business is under the credit of creditors or credit agencies, managers are more prone to corporate planning, regular debt settlement, reporting, and risk management.
4.) The debt creates a tax shield
The cost of debt is actually lower when taking into account the tax effect, e.g. If the interest rate is 5%, and the profit tax rate is 20% then the price of the debt is actually only 4%. Interest expense is a tax deductible expense that diminishes the income tax base. Thus, societies have a tax shield when they are financed out of debt. This because they are able to reduce the tax base and, therefore, the cost of tax. This is an advantage over the companies that are 100% financed from the capital because dividends are not an expense and do not diminish the tax base.
5.) The debt serves as a financial lever
Debt is also beneficial to existing owners due to the impact of the financial leverage. When a company uses a debt to finance the business, the owners of the capital retain all the extra profit generated from the debt after the interest expense is settled.In this way, investors have a higher return on investment (ROE = Return on Equity). As long as the debt does not endanger the company’s financial solvency in times of crisis, debt increases the return on invested capital.
The aim of the company is to increase the economic value (eng.EVA = Economic Value Added) by maximizing the return on capital employed (ROCE) and minimizing the cost of capital (WACC). The above assumptions imply that a company should have a debt in its balance sheet to the extent that the financing cost (WACC) is at the lowest level.
The debt is desirable to a certain level. Defining the optimal level of debt is not an exact science, but requires a common sense and judgment that takes into account the nature of the company’s business. When deciding on the level of debt, regardless of the amount of mathematical calculations, always include common sense. Instead of thinking about how to avoid debt, think how to make debt for you.
This all is how some of the best and riches companies in Singapore made a living out of it and increased BDP of their state and one of the men they can thank to is mr.sc.DanijelPevec which worked with top companies in Singapore and helped their country with their development. Thanks to his tips it blossomed, and thanks to him also these debt thoughts that we have written are his guidances to success.
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