Debt or Equity - An SME's Perspective

Attention all business owners! Whether you are a small startup or a medium-sized firm with multiple regional presence, this question will always pop up once in a while in the course of your entrepreneur journey. Perhaps during expansion when additional funds are needed, purchase of large machinery, working with your suppliers and customers who are performing credit analysis on your financial statements. These are some of the times that you will be concerned about your Debt and equity structure. We hope that through this article, you will have a greater appreciation of what needs to be done at each crossroad and assist you in making the right decision for your business.

For small and medium-sized enterprises (SMEs) in Singapore, navigating the path of financing their business growth is critical. One of the most fundamental questions they face is whether to use Debt or equity financing. This decision not only affects the company's financial health but also its control, risk, and long-term sustainability. In this article, we will discuss the key concepts of Debt and Equity, weigh their pros and cons, and explore how SMEs should strategically balance these funding sources as they evolve.

1) What is Debt and What is Equity?

Debt and Equity are two primary forms of capital that businesses use to fund operations, expansion, and growth.

Debt refers to money borrowed from external sources, typically in the form of loans or bonds, that must be repaid over time with interest. The lender does not gain any ownership or control of the company but expects repayment according to the terms of the agreement.

Equity, on the other hand, refers to ownership in a company. It is raised by selling shares or ownership stakes to investors in exchange for capital. Equity holders, such as shareholders, become part-owners of the business and share in both the profits and losses. Unlike Debt, Equity does not need to be repaid, but shareholders may demand a return on investment through dividends or appreciation in share value.

For many SMEs, especially those in the startup phase, equity financing tends to be the most common choice due to the limited access to traditional debt financing. Startups often lack the proven track record or assets to secure loans.

What Do SMEs Usually Begin With?

During the early stage of an SME's development, owners typically use a mix of personal savings, funds loaned "personally" from family and friends, and Equity raised from angel investors or venture capitalists. All these are regarded as debts. In uncommon cases, debt financing, such as bank loans or personal loans secured by the company, are hard to come by at this stage due to the risks involved and the lack of collateral.

2) The Pros and Cons of Equity and Debt Financing

Both Debt and equity financing come with their own set of advantages and disadvantages. Understanding these will help SMEs make informed decisions about their financial structure.

Pros of Equity Financing:

• No Repayment Obligation: Unlike Debt, Equity does not need to be repaid, which can provide greater cash flow flexibility.

• Lower Risk: Equity investors assume the risk of the business, not the company itself. If the business fails, equity investors lose their investment, but the business is not burdened with Debt.

• Access to Expertise: Investors, especially venture capitalists, often bring valuable business expertise, networks, and guidance to the company. Sometimes, you don't get just their funds but also their involvement. (Did you watch Dragon's Den? That is Equity – You will always hear them trying to sell x % of their company's stake for a certain amount)

Cons of Equity Financing:

• Loss of Control: Selling Equity means giving up a portion of ownership, which can dilute the founder's control over the business. This dilution can be critical and result in difficulty in decision-making. One may also encounter ambiguity or confusion regarding newly onboarded shareholders' roles, responsibilities, and the company's general direction.

• Profit Sharing: Equity holders are entitled to a share of the profits, meaning the company's earnings must be divided among shareholders. If the company belongs to you, you get all the gains; you bear all the risk of losses. However, sharing this with someone else will reduce your profit in good times and incur fewer losses in bad years.

• Soft-pressure of dividends: Investors wish to see a return on their investment. It will face soft pressure to manage shareholders' expectations by opting to sell the company's shares. Suppose there is no dividend or capital appreciation; investors may choose to exit. This will be disastrous if they bring about critical knowledge or contribution to the firm.

• Long-term commitment: Sales of shares are a permanent arrangement, so this can be a downside if the funds required are only on a short-term basis.

Pros of Debt Financing:

• Retain Control: Debt financing does not involve giving up ownership or control of the business.

• Tax Deductions: Interest payments on Debt are tax-deductible, which can reduce the overall tax burden.

• Predictable Payments and Short-Term Commitment: Debt has fixed repayment schedules so that businesses can plan for consistent cash flow management. The obligation will be legally extinguished once the Debt is repaid in full (Principal + Interest). This is attractive when funds are only required temporarily, such as purchasing a large machinery that can achieve breakeven in 18 months.

Cons of Debt Financing:

• Costs and Repayment Pressure: Regular interest payments, regardless of the business's financial situation, can strain cash flow. Debt tends to be much more expensive in the short run, depending on how you view it (Some might regard Equity as the more costly option considering its perpetual nature and the company's growth rate). On paper, interest repayment is a legal obligation, while dividends under equity financing are not mandatory.

• Risk of Insolvency: Failure to meet debt obligations can lead to bankruptcy or liquidation, which is a significant risk for any business. This issue is common, especially when a company fails to accurately plan for its cash flow before taking up debts. Over-committing to Debt or being over-optimistic in their cash flow is a common downfall of insolvency.

• Collateral Requirements: Lenders may require assets as collateral, putting company assets at risk in case of default. Covenants may also be present. Under both collateral or debt covenants, these agreements may place certain restrictions on your assets or financial ratios.

  
  

Summary Table of Pros and Cons:

3) Debt-Equity Structure for SMEs as They Develop

As an SME transitions from the startup phase to growth and maturity, the balance between Debt and equity financing will typically evolve.

Companies are more likely to rely on equity financing in the startup phase. With limited assets and revenue, they often face difficulty in securing loans. The business is seen as a high-risk investment, so investors (equity holders) take on the risk in exchange for potential rewards.

However, as the company matures, its debt-equity ratio begins to shift. With a proven track record and increasing revenues, businesses may become more attractive to lenders, enabling them to take on more Debt. Debt financing can be beneficial as the company seeks to scale operations or make significant investments. As a result, businesses begin to mix Debt and Equity more strategically, often opting for a ratio that balances the need for capital with the ability to service Debt.

Different industries may exhibit different debt-equity preferences based on their capital requirements and risk profiles. For example, capital-intensive industries such as manufacturing or real estate may rely more on debt financing due to their higher asset base and cash flow stability. On the other hand, tech startups or service-based businesses may prefer equity financing because they often have fewer tangible assets and need flexibility in cash flow.

4) Understanding Debt-Equity Ratio

The Debt-Equity Ratio (DER) is a key financial ratio used to evaluate a company's financial leverage. It measures the proportion of Debt used to finance the company's assets relative to Equity. The formula for the debt-equity ratio is:

Debt-Equity Ratio =Total Debt/Total Equity

Where:

• Total Debt refers to all short-term and long-term liabilities of the company.

• Total Equity refers to the owner's equity or shareholders' equity.

The debt-equity ratio is an important metric for investors, lenders, and business owners as it helps assess the financial stability and risk of the company. Sometimes, suppliers may also be concerned if the debt-equity ratio is exceptionally high, which suggests a lowered liquidity capability (This is not conclusive and acts only as a superficial indicator). A high debt-equity ratio indicates higher risk, as the company is more reliant on borrowed funds. In contrast, a lower ratio suggests more conservative financing with a heavier reliance on Equity.

Who Uses the Debt-Equity Ratio?

1. Investors use the ratio to evaluate the company's risk level and potential return on investment.

2. Lenders, including banks and suppliers who offer credit terms, assess the company's ability to repay Debt and evaluate its financial health.

3. Company Management uses it to make informed decisions about capital structure and funding strategies.

   
   

Is a Single Debt-Equity Ratio Enough?

A standalone debt-equity ratio is insufficient to assess a company's financial health. So there is no good or bad ratio just by having a look at this figure. It is essential to compare the ratio against:

• Historical data: To observe how the company's leverage has changed over time.

• Industry benchmarks: To see how the company fares against competitors in the same industry.

• Competitors' ratios: To understand how the company compares to its peers.

There is no single optimal debt-equity ratio, and this alone does not paint any helpful picture. It should be combined with the company's historical data and benchmarked against competitors and industry averages. One should also consider the company's operation to evaluate if the debt-equity ratio movement coincides with major business decisions.

5) The Importance of an Optimal Debt-Equity Ratio

An optimal debt-equity ratio is crucial for maintaining a balanced and sustainable financial structure. An optimal ratio allows an SME to maximize its growth potential while minimizing the risks associated with Debt.

Having an optimal ratio ensures that:

• The company can raise capital without being overburdened with Debt.

• Shareholders' interests are protected without diluting ownership too much.

• The business can withstand economic downturns and other financial challenges.

An experienced consulting firm like ours can help SMEs achieve this balance. We can assess your company's risk profile, identify potential financing sources, and recommend strategies to optimize the debt-equity ratio. Our team can guide you through the complexities of financial decision-making, ensuring your business remains on a steady path toward growth and profitability.

Conclusion

Navigating the decision between Debt and equity financing is crucial to building a successful SME in Singapore. Both Debt and Equity come with their own set of advantages and risks. As an SME grows and matures, the balance between these two financing sources will evolve, and the key to success lies in maintaining an optimal debt-equity ratio. There are a million points to consider when you want to optimize your debt-equity structure, and perhaps you have a few driving reasons to do that. Common reasons that we encounter include:

• Optimise financial ratios to secure loans or supplier KYC

• Increasing profitability

• Improving cash flow

• Onboarding or attracting valuable investors

With the support of an experienced consulting firm, businesses can focus on a few key points of consideration to manage their financial structure effectively and meet their goals. Contact us now to understand what we can do for you regarding debt-equity structure consulting.

References

https://www.investopedia.com/terms/d/debtequityratio.asp

https://www.digitalocean.com/resources/articles/debt-vs-equity-financing

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DISCLAIMER: The views and opinions expressed in this article are those of the author and do not necessarily represent the views and opinions of any individuals or organizations with which the author may be affiliated, either in a professional or personal capacity, unless explicitly stated.

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