After a period of interest rate increases by the Federal Reserve, it appears that lower rates might be back in style. In September 2019, the Fed announced a cut in the federal funds rate. Lower interest rates mean less expensive loans, which makes borrowing a more attractive option for business owners looking for cost-efficient ways to raise capital.
Debt often has negative connotations, as it is typically associated with borrowing too much money or not being able to keep up with payments to creditors. But for businesses, debt can be a powerful tool to help them get funding for operating costs or expansion. By strategically taking on debt when interest rates are low, businesses can access the cash they need while maintaining their overall fiscal health.
Breaking Down the Basics of Debt Financing
There are two common methods for businesses to raise capital: the first is through equity, providing investors with an ownership percentage in exchange for financial investment. The other is raising capital through debt, whereby a company raises money by borrowing from individuals or equity firms. In exchange for the money, a business provides its lender with a bond, bill, or note that outlines when and how the lender will be repaid. The business then pays the lender back the sum of the funds (also known as the principal), as well as any interest that may be owed as part of the agreement.
Debt financing has several advantages over equity financing. For starters, it allows businesses to retain ownership of their company without having to take on additional investors. Once the debt is repaid, the lender's stake in the business is no longer a factor. This can help retain the value of individual shares in a company, since lenders don't assume shares in exchange for capital.
There are some potential disadvantages to debt financing, however. For example, if a business experiences financial trouble, their lenders are the first to get paid out. Equity stakeholders, on the other hand, are usually the last parties to get paid in these scenarios.
Looked at another way, debt financing provides lenders with an immediate opportunity to invest and reap dividends, but offers no long-term stake in a company's success. Equity investing, on the other hand, means assuming the risk you may be the last person to recoup your financial stake in a business, but could also reap greater dividends if the business takes off.
How Interest Rates Affect Debt Financing
Debt financing is, in many respects, similar to taking out a business loan. A company requests a certain amount of capital to borrow (considered the "debt" in this scenario), and a lender will offer that cash in exchange for a pre-determined repayment schedule, plus interest on the total value of the loan. This interest is typically calculated as a percentage of the loan's total.
Lenders look to current interest rates when determining what percentage they should charge borrowers. The Federal Reserve sets the interest rate that banks use when lending money to one another, which also serves as informal benchmark that lenders use when providing loans to businesses and individuals. The Fed will often lower interest rates to encourage borrowing, thus stimulating economic growth. Low interest rates mean less expensive loans in the long-term, which can help businesses finance their large-scale projects more effectively.
Why Raising Capital Through Debt Makes Sense While Interest Rates Decline
Raising capital through debt means paying a premium in order to access the cash your company needs. Timing out when and how you raise capital through debt can help you make your money stretch further.
It's important to bear in mind that it's almost impossible to time these interest rate fluctuations perfectly. What may seem like a low interest rate today could be eclipsed by another rate slash in the future. Or you could just as easily wait for rates to drop and end up with a rate increase before you lock in your rate. That's why it's helpful to consider market trends, financing needs, and your company's overall fiscal objectives when looking to raise capital through debt.
If you don't need to raise capital immediately, it may make sense to wait and observe general interest rate trends before taking the plunge. You still may not lock in the lowest rate possible, but you could stand to pay less interest by waiting for the right time.
Last but not least, raising capital through debt means retaining equity in your company. The long-term ramifications of paying interest in exchange for capital tend to be less significant than raising capital through equity.
When you exchange equity for capital, you give up a portion of ownership in your business. What's more, you may also give up more money down the line. If your business expands, your investors' equity becomes more valuable. The more valuable their equity becomes, viewed as a percentage of ownership, the larger the slice of the pie they're entitled to receive. Plus, keep in mind that adding owners means they'll also have a say in how you run your operation.
How to Determine if Raising Capital Through Debt Makes Sense for Your Business
So how should businesses decide between raising capital through debt versus equity? For starters, you may want to consider debt financing if you want to retain full ownership of your company. If you can afford the loan and are able to lock in a good interest rate, then your obligation to your creditors is finished as soon as you've made your last payment.
On the other hand, the short-term benefit of raising capital through equity might be a better option for businesses that can't afford to take on debt and are willing to risk giving up some control over operations.
Leveraging your relationship with a commercial banker—who is familiar with your business operations and goals—can help determine what makes the most sense for your business.
If Fed rate cuts are here to stay, businesses will be able to make their money go further by paying less in interest during a period of cheaper money. Plus, they’ll retain current control over their enterprise without having to give their creditors a seat at the table. So long as individual business owners know the risks of debt financing, and have made sure that their companies can withstand debt, they can prime themselves with a savvy way to access the capital they need.