Pros And Cons Of An Under Debt Life
Debt is generally considered bad by our forefathers. We always listen to them saying that never incur a debt, it will land you in a mess. Still, nowadays, a loan or a liability is an inherent and unavoidable part of our lives be it a human or business. We will hardly find someone who does not have a liability depicted in his balance sheet. If we can find one, then it can be said with a hundred percent confidence that such a person is not at all financially literate. The richest people or companies of this country are not free from the tag of the under debt life.
This transition is the foundation of modern financial planning. Henceforth, we must understand the meaning of the under debt life, the pros and cons of the debts as well as the factors that have led to this transition.
Meaning of debt
In simple words, debt is any amount borrowed by one party from another. It has a rate of interest and repayment of the period attached to it. In the accounting terms, a debt is known as that financial component the payment of which results in the decline in the asset base. In other words, whenever one pays a loan, an asset is decreased, either bill receivables, cash, bank or any other asset. There is always a decline in both sides of the balance sheet unless another liability has been incurred to pay the previous one.
The loan includes debt, mortgages, bill discounting, and even credit card debt. Credit card debt is the most common form of loan amongst individuals. We go for the shop, we punch the credit card, we incur a debt. Unlike other forms of debt, credit card debt does not have a fixed monthly instalment amount that is needed to be paid. The amount varies as per the expenses incurred with the use of that card over a stipulated period in addition to the interest.
As the credit card and loans are not enough for the financing of the company, there are several other forms of debt. Bonds, Debentures and commercial papers are such debt instruments that are not available for the individuals. Bonds, debentures are purchased by the people who seek investment is business houses for the long term. They are the big investors whose earnings are dependent on the company in which they are investing. On the other hand, commercial papers are offered for a shorter period.
Pros of debt
- Maintain ownership: In the case of companies, when the funds are raised through the debt, the decision making authority is retained with the owner of the company. Whereas when the funds are raised through shares or other options, it results in the dividing ownership of the company.
- Financial leverage: The benefit of financial leverage can be availed through the introduction of debt into the capital structure of the company. It refers to the use of debt for the acquisition of additional assets. The use of financial leverage will lead to an increase in the returns of the owners of the company.
- Tax deductions: While calculating the corporate taxes, if often happens that the business loan amount and the interest payments thereon are considered as business expenses. Therefore, they are deducted from the taxable income of the business at the time of calculation of tax.
- Increased growth prospects: Debt opens the opportunities for growth of the business. Taking a long term loan will solve the problem of cash or financial crunch in the company. Hence, the working capital needs are satisfied, so the company remains profitable around the whole year. It also results in increased expansion opportunities.
- The quick raising of money: Debt financing requires less amount of times as compared to the public issue of shares. Also, one can arrange funds at the time of need through debt such as commercial papers and bank loans.
- Useful for small businesses: Debt financing is really useful for small businesses. Small businesses cannot raise money through other sources of finance, unlike big business firms. Also, debt financing cuts in the high cost of raising funds, reduction of monthly payments. This small reduction has a multiplicative effect and can boost the business off the ground.
Along with these pros, there are also several cons associated with it, which are as follows:
- Repayment of amount: The fist and the foremost demerit of debt financing is the repayment of the amount taken. Since it is a liability, it has to be paid back sooner or later to the lender. This does not happen in case of the public raising of funds, the amount does not have to be paid back until the company has wound up. Even in that case, there is no guarantee that funds will be returned to the investor.
- Collateral requirements: A debt cannot be taken unless the collateral is there except in the cases of the unsecured loans. The lender has to be sure that his amount is secured so that in the event of nonpayment of the loan amount, the collateral can be used.
- High rates: Even after taking into account the tax deductions and other benefits from debt financing, the debt may still prove to be an expensive option. This happens because of the several factors that are not in the control of the business enterprise such as macroeconomic conditions, credit history, etc.
- Impact on credit rating: Loans pose an impact on the credit rating. Every time a loan is taken by the owner, it impacts the credit score of the borrower. One needs to be cautious in this regard that the loan credit rating does not decline to a danger area.
- Fees on the processing of the loans: Additional fees are charged on the processing of loans by the lending institutions that automatically add up to the amount to the loan.
So, where to go now? It is widely known that debt financing is used by the biggest companies in the world to raise finances and fuel their growth plans. However, they ensure that the loan provides benefits to the company instead of adding up to the cost structure. This is known as a good loan. The opposite of this is termed as Bad loan in which the loan does not benefit the company. Here, certain factors are needed to be kept in mind. For instance, if the loan amount increased beyond a particular level, the benefit of financial leverage will turn to cost. Also, if the money is invested in the assets through which returns are not evident in the near future, then it will turn to a bad loan.
Today, debts are not considered a bad thing if one has a sense of purpose. The business firms which are suing debt are flourishing today. This has been achieved through better planning and increased education in the field of finance. In case, one has a confusion regarding what to do, advice of tax and financial professionals can be taken. Indifi is a market leader in this space. We will be happy to help. Feel free to reach out in case of any queries.