Debt Financing

Debt finance is the formal name for borrowing money from a third party with the obligation to repay the principle plus the agreed-upon rate of interest. When most people think of borrowing money, they picture a bank, but small company owners have access to a wide range of debt financing options. Peer-to-peer loans, business loans, credit cards, and microloans are a few examples.

Before borrowing any money from a third party, there are a number of debt financing advantages and disadvantages to take into account. These must be carefully considered, and it’s crucial to keep in mind that what works for one owner of a business might not be the best course of action for another.

The major Advantages of Debt Financing are the following:

1. Credit Issues

If you have credit issues, equity financing may be your sole option for funding expansion. Even if debt funding is available, it may have an unacceptably high interest rate and harsh payments.

2. Retain control of Your Company

Even if angel investors and venture capitalists can support your firm financially, they could meddle with how it runs. However, if you choose debt finance for your company, you will receive the money and the flexibility to conduct business as usual. Although you can be confident that your lender won’t interfere with how you operate your business, they will charge you interest on the money you borrow.

3. Tax Deductions

Unexpected to some, taxes are frequently a crucial factor to take into account when deciding whether or not to employ debt financing for your business. Why? The principle and interest payments on business loans are sometimes included as company costs. These can be written off against your business income taxes. The government is, in some ways, an equity partner in your company.

4. Cash Flow

 The firm does not lose money when equity financing is used. Repaying debt loans depletes the company’s cash flow, which lowers the amount of money required to finance expansion.

5. Financial Planning Made Simpler

You are completely aware of the precise principle and interest payments you will need to make each month. This makes creating a budget and financial planning simpler. You may use a business loan EMI calculator to schedule your payments. Enter the loan’s amount and term. The calculator will determine your EMI payment and the total amount due.

Financial budgeting is made simpler when you are aware of your particular monthly spending requirements in advance.

6. Reduced Interest Rates

Your total tax rate may change as a result of tax deductions. A tax benefit of going on debt is frequently possible. As an illustration, you may calculate the following if your bank charges you 10% interest on a business loan and the government levies a 30% tax on you. A percentage of 7 percent is obtained by multiplying 10 percent by (1-30%). You will pay a 7 percent interest rate as opposed to a 10 percent rate once your tax deductions are taken into account. In terms of money, it’s a move that benefits both of you and lowers your tax rate while enabling you to receive the funding you need to expand your company.

7. Less Risk

Since you won’t be required to make any set monthly loan payments with equity financing, there is less danger involved. This is especially useful for new enterprises that might not have a positive cash flow in the first few months.

8. You Will Create and Grow Your Company Credit

Working cash shortages are one of the main causes of failure for small firms, claims Investopedia. When looking for low-cost, long-term debt financing, excellent company credit is essential. As a result, a significant and essential benefit of getting a loan is being able to establish your business’s credit. The need to rely on your personal credit or other expensive business funding solutions decreases as your small firm’s credit grows. Establishing more advantageous arrangements with vendors might be facilitated by having good company credit.

What CA should Keep in Mind while Incorporating Taxes Benefits on Loans

Both are legally binding papers that will be accepted by courts in the event of a disagreement.

If you want to keep things straightforward and only for the record, use a promissory note, which is an unconditional guarantee by the borrower to pay a certain amount on demand or at a given date.

This document must be signed by the borrower and is governed by Section 4 of the Negotiable Instruments Act of 1881. It comes in a variety of forms, including single and joint borrowers, payable on demand, payable in instalments or in one lump sum, and payable with and without interest.

The structure is basically the same, but the terms and conditions are changed by adding or changing a few phrases. Documents pertaining to loans must be drawn up on stamp paper and notarized. They allow you to include as many provisions as you’d want, including ones on collateral, default, termination, and inclusion of legal heirs.

Word choice is important. Clearly state the date and location, and include complete names. It is important to use precise language when addressing issues like tenure, frequency of payments, and the method of calculating interest (simple, yearly compounding, etc.). Complete the purchase using a Bank cheque, and provide the cheque number in the agreement.

It is recommended to have a witness, ideally one who is not connected to either of the two parties, sign the document even if it is not legally required. In the event of a dispute, this will be persuasive.

In addition to not being taxed, family gifts and loans are also exempt. But any gift from a within a fiscal year that is greater than Rs 50,000 is taxed. The transaction becomes tax-free, nevertheless, if it’s a loan.

Therefore, if your buddy gives you Rs 60,000 in cash, you must pay tax on the sum; but, if the money is in the form of a loan that you must repay, there is no tax to be paid.

For both lenders and borrowers, interest-free loans are not taxed. But it becomes tricky because the lender would have to pay tax on the interest they earn if there is a provision for interest payment. It depends on the loan’s purpose whether the borrower must pay tax on the interest received. If you borrow money for personal purposes rather than, instance, purchasing a property, you won’t receive any tax benefits under Section 24.

Additionally, loans made outside of institutions are ineligible for tax deductions under Section 80C. In other words, you won’t be able to deduct the principal from your taxes. However, unlike a buddy, a bank would never give you a loan at a reduced rate of interest.

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