A company needs money i.e. capital to run its operation. The two major sources of capital are debt and equity. The capital structure of a company is a combination of debt and equity. Loans and bonds are forms of debt, while equity includes selling ownership stakes in the form of shares to the public or a particular entity. A company’s optimal structure is one where there is a mix of both equity and debt.
We all think that a company that doesn’t have any debt on its balance sheet is a profitable one. But this is not always the case. Of course, having no debt is positive. However, having debt has some benefits. The first one is that the interest on debt is tax-deductible. Interest is a cost to a company for raising debt. And this cost is deducted from profits before calculating tax expense which results in tax savings. Another advantage of having debt in capital structure is that if the company is profitable and has paid all its loans on time, they can bargain a lower rate for interest from the banks. This results in a lower cost of capital.
Furthermore, in a big public company, managers are given a fixed budget to spend their money on profitable projects. There are often cases where managers tend to waste this money on useless projects just for the sake of spending money. Having debt forces a sense of discipline on the managers to pay the fixed interest payments on the loans. It is similar to buying a car on EMI, you have to go to work and earn money to pay off the dues.
Considering these benefits, having debt in the capital structure can be a good idea but taking on too many loans will cause financial distress which will ultimately lead to bankruptcy. A company needs a healthy mix of debt and equity that will increase its efficiency of operations and result in profits!
Concept: Shivangi Bhatia
Editor: Minakshi Todi