5.4. Financing a Business
NOTE
To run a business, you need financial backing, otherwise known as capital. In broad overview, a business raises capital needed for its assets by buying things on credit, waiting to pay some expenses, borrowing money, getting owners to invest money in the business, and making profit that is retained in the business. Borrowed money is known as debt; capital invested in the business by its owners and retained profits are the two sources of owners' equity.
How did the business whose balance sheet is shown in Figure 5-2 finance its assets? Its total assets are $14.85 million at year-end 2009. The company's profit-making activities generated three liabilities — accounts payable, accrued expenses payable, and income tax payable — and in total these three liabilities provided $1.78 million of the total assets of the business. Debt provided $6.25 million, and the two sources of owners' equity provided the other $6.82 million. All three sources add up to $14.85 million, which equals total assets, of course. Otherwise, its books would be out of balance, which is a definite no-no.
Accounts payable, accrued expenses payable, and income tax payable are short-term, non-interest-bearing liabilities that are sometimes called spontaneous liabilities because they arise directly from a business's expense activities — they aren't the result of borrowing money but rather are the result of buying things on credit or delaying payment of certain expenses.
It's hard to avoid these three liabilities in running a business; they are generated naturally in the process of carrying on operations. In contrast, the mix of debt (interest-bearing liabilities) and equity (invested owners' capital and retained earnings) requires careful thought and high-level decisions by a business. There's no natural, or automatic, answer to the debt-versus-equity question. The business in the example has a large amount of debt relative to its owners' equity, which would make many business owners uncomfortable.
Debt is both good and bad, and in extreme situations it can get very ugly. The advantages of debt are:
Most businesses can't raise all the capital they need from owners' equity sources, and debt offers another source of capital (though, of course, many lenders are willing to provide only part of the capital that a business needs).
Interest rates charged by lenders are lower than rates of return expected by owners. Owners expect a higher rate of return because they're taking a greater risk with their money — the business is not required to pay them back the same way that it's required to pay back a lender. For example, a business may pay 6 percent annual interest on its debt and be expected to earn a 12 percent annual rate of return on its owners' equity. (See Chapter 13 for more on earning profit for owners.)
The disadvantages of debt are:
A business must pay the fixed rate of interest for the period even if it suffers a loss for the period or earns a lower rate of return on its assets.
A business must be ready to pay back the debt on the specified due date, which can cause some pressure on the business to come up with the money on time. (Of course, a business may be able to roll over or renew its debt, meaning that it replaces its old debt with an equivalent amount of new debt, but the lender has the right to demand that the old debt be paid and not rolled over.)
