Entrepreneur's Handbook
BASIC FEATURES OF DEBT AND EQUITY AND FINANCING
The main sources of funds for the entrepreneur when starting a new business are equity (equity, ie own money) and debt called foreign sources.
Equity is a resource with an infinite maturity. Since the life of the business is considered to be infinite (the concept of business continuity), the maturity of equity is also infinite depending on this concept. Theoretically, the return (cost) of equity, which is a shareholder money, is higher than the cost of debt. The mentality of "This money is my money, how can it cost" expressed by many entrepreneurs is not correct. Entrepreneurs who do not know this fact will see that the value of their venture decreases rather than increases over time, since they will set a target below the expected return on their investment.
In financing, there is a separation of short and long terms for debts. Short-term debts are debts that must be paid within a year, while long-term debts are debts with a maturity of more than one year. The portion of long-term debts that will be paid within one year is also considered as short-term debt. Lending institutions hold higher interest on long-term loans because uncertainty is greater in the long term. On the other hand, as the maturity of the debt increases, the liquidity risk for the entrepreneur (here, the status of repaying the debt within a year) will decrease, but the cost of the debt will also increase. Therefore, short-term debts are debts with high liquidity risk but lower interest rates. Long-term debt is debts with low liquidity risk but higher interest. The entrepreneur is initially advised not to use debt if possible, but if he cannot find enough equity or government support, he may be advised to use debt. Although the cost of debt is high, the priority should be long-term debt. Because the first years of the enterprise are difficult years. In these years, it is likely to be below the sales and profit targets set at the beginning. Therefore, it is unlikely that short-term debts will be paid on time. Unless it is absolutely necessary, short-term credit should not be used, if it is, it should be used when financing stocks and receivables. However, when financing fixed assets, short-term debt should not be used. This is a very risky option. This is the mistake most failed entrepreneurs make (Aktaş, vd., 2008).
These alternative sources have certain benefits and drawbacks. Generally, the benefit of one is the disadvantage of the other. By looking at these benefits and drawbacks, the entrepreneur should draw his own road map in financing.
The benefits of debt financing compared to equity financing are as follows:
- The cost of debt (interest) does not increase depending on the earnings of the business. The cost of the debt is fixed. Lenders cannot demand an additional return because the income of the entrepreneur or the enterprise established by him has increased,
- The cost of debt is lower than the cost of equity, contrary to popular belief. The main reason for this is that the credit rights of the lenders over the assets of the business in case of liquidation of the business have priority. In other words, in case of bankruptcy of the enterprise, when the assets are converted into cash, first of all, payments are made to the lenders. When the payment to the lenders is completed, the remaining amount is only distributed to the equity holders, namely the company partners. Hence the risk incurred by equity holders is higher and therefore the return they demand (cost of equity) must also be higher. Otherwise, no one would want to risk starting a business or becoming a partner. Naturally, lending would be a more rational decision. As a result, the relationship between "high risk and high return", which is one of the basic principles of finance, is also valid here.
- The tax advantage of using debt is generally greater than financing with equity. In other words, all of the interest and other expenses paid for the debt can be deducted from tax.
- Another benefit of debt financing is that it does not put the entrepreneur at risk of a limitation or loss of control in the management of the business. When debt is used, the entrepreneur is not obliged to share the management and control of the firm with the lenders.
On the other hand, the disadvantages of debt financing compared to equity financing are as follows:
- The use of debt obliges the entrepreneur to make a certain payment as of a certain date. Because when using debt, the entrepreneur undertakes to make the principal and interest payments to the creditor on time. If the income obtained by the entrepreneur as of the relevant period is not sufficient to make the payments for the debt used, the enterprise may go into bankruptcy.
- Excessive borrowing increases the entrepreneur's (business) risk. This is called increasing the degree of financial leverage. Increasing the degree of financial leverage may increase profits while things are going well, but as the name suggests, leverage can lower it as it brings it up. When the firm has difficulty in selling, every loan used is now a burden for the firm. At the same time, another risk of using excessive debt is that as debt increases, it becomes difficult to find new financial resources under suitable conditions. Banks are not willing to lend to the over-indebted firm. They think that using excessive debt also increases the risk of moral risk. (Why? Answer: Because in general, people tend to risk someone else's money more easily.) (Brealey, vd., 2007).
- It may be necessary to provide collateral in borrowing. If no collateral can be found in the case of showing collateral, it will not be possible to use credit.
As mentioned earlier, the disadvantages of debt financing are the benefits of equity financing, while the benefits of debt financing are equity financing.