Debts as a source of operating funds can be from within or outside the company specifically individual borrowings or banks. Equity on the other hand a source of funding that results from sale of securities (shares/stocks). In determining the company progress the ratio of debt to equity as source of company funding is of fundament since it indicates how the company is able to leverage its operation depending on the state of the economy.
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When a company does not have enough retained earnings, it must consider and evaluate whether to raise funding by issuing shares or borrowing form banks and financial institutions. This is because operations are likely to stall without enough capital to run the firm. When it gets the funding from debt financing, the companies balance sheet is vastly affected devastating the financial position of the business. This is because raising more money through debt compared to equity i.e. loans increases the companies debt ratio. Debt financing is not recommended for a business mostly when the financial markets are not favorable since there is high risk of default.
The income tax deduction benefit is also highly decreased during such economic times due to the inflated cost of capital in the financial markets. Debts also imposes the business to a lot of uncertainty hence highly risky for corporations during hard economic times, therefore during bad financial times the debt-equity-ratio should be made as low as possible. During hard economic times costs of operating the company should be minimized as we maximize the revenue. Debt is again discouraged since they come with high interests that is costly to the business, interest are obligatory in nature and cannot be ignored or avoided legally.
Considering tax implications, interests on loans are highly taxed hence should be avoided. Taxation on debt does not replicate on the share price and incase of financial difficulties in the business, debt must be paid back hence more difficulty or even collapse of the business. During instability in the financial markets corporations and businesses should go for equity as their major source of funding. This has the effect of lowering the debt-equity-ratio which busts the health of operations.
Such actions come with benefits such as: – financial benefits to the shareholders through payments of dividends which are not a must as well, the dividend can be regulated or stopped at any given time depending on the state of the economy and company operations. Dividends do not attract taxation nor is tax non-deductible hence saving the company on taxation costs. According to the investor’s perspective, double taxation of the dividends according to the IRS standards leads to appreciation of stock prices with a likely effect of improving the profitability of the business and investors wealth.
Companies with low debt to equity ratio have less legal obligations because stocks do not need to be refunded back incase of financial distress as opposed to interest which is a must pay even at bankruptcy and they must be paid before any other action. This is because the investors become part of the company and also they expect to reap their investments from future profits of the business. Therefore, it is prudent to continue raising money for business operations through equity during hard financial times though the method is considered more appropriate for young corporations which cannot adequately service loans.