When a corporation needs money for any purpose, there are two main ways it can obtain it. The first method is getting a loan, and this option is considered obtaining capital through debt. The other method is selling stock for cash, and this option is considered obtaining capital through equity. Both options are effective and good; however, there are several key differences between the options. Here are several things to know if you are trying to determine which option to use for your corporation.
Methods For Repayment Of Debt
Taking a loan to get cash for your business is a common method used; however, this method involves signing a contract. When your company borrows money, the contract will state the:
- Amount borrowed
- Interest rate
- Payment schedule
In other words, you will have to pay back the money either through monthly payments or with a balloon payment. If you fail to pay the money, the lender may assess late fees and may send your debt to collections.
The other method for obtaining capital is through selling stock. Selling stock is a method that allows you to obtain cash without having to necessarily repay it. In addition, if you decide to sell stock instead of borrowing money, you will not have to worry about monthly payments on the debt. The downside to this is that you are actually selling part of the rights to your company.
Interest On Capital
The second difference to consider is the amount of money it will cost you to obtain the cash your company needs. When you borrow money from a bank, the bank will make you pay interest. This means you will not only owe the entire balance of the loan, but you will also pay interest, which is an added expense to this.
When a company sells stock, it does not actually make or lose money on the sale, and the only time a company would have to pay out money for a stock is if it decided to buy back the stock. The good part about this is there are no payments to make and no interest to pay.
Effects On Financial Statements
The third difference involves the way each type of debt affects a company's financial statements. This difference often involves analyzing the way a company funds itself. If you look at a company that does not sell a lot of stock, but instead uses loans to borrow most of the money needed, the company would have a really high debt-to-equity ratio. Investors may view this negatively, in some cases, because it can mean a company is highly leveraged with borrowed money.
On the other hand, if a company raises most of its money by selling stock, the debt-to-equity ratio would be extremely low, because the majority of its capital came from selling stock. This can make the financial statements appear better for investors.
The reason is that when a company borrows money through debt capital, it is obligated to pay it back by a certain date. When this is the case, it can create cash flow problems for a company. When a company has a low amount of debt capital, it is not tied to a fixed repayment schedule that will have major effects on its cash flow.
Both methods of obtaining cash are good, but there are times when one option is better than another. If your company is low on cash and needs to find a way to get some, you may want to see this site to talk to a corporate lawyer to determine which option would be feasible and right for your business.