Every company which is doing business has to borrow capital from outside as it is not practically possible to fund the expansion of the business through owners own funds. Borrowed capital is like oxygen mask which gives a new lease of life to business dying due to the shortage of funds. Borrowed capital refers to that capital which the company takes from outsiders like the loan from banks or financial institutions, issuing debentures to debenture holders, taking unsecured loans and so on. In order to understand this concept better let’s look at advantages as well as disadvantages of borrowed capital
Advantages of Borrowed Capital
- The first and foremost advantage of borrowed capital is that it helps in reducing the cash crunch of the business because a business can run for short period of time on owners funds but if one wants to run a successful business for long period of time than he or she has to take borrowed capital and use that capital to take advantage of profitable opportunities arising in normal course of business.
- Another advantage of borrowing capital is that rate of interest on borrowed capital is fixed and therefore company knows that how much interest company has to give to the borrowers whereas growth rate of profit is not fixed and company can earn the much higher rate of profits than the rate of interest it is paying it to the borrowers. In simple words, the company can leverage borrowed funds in the business to make higher profits.
- Another benefit of borrowed capital is that since creditors do not have any voting right they do not interfere in the management of the company and hence the owners of the company have full control over the matters of the company resulting in greater flexibility and conviction in the decision making of the top management.
Disadvantages of Borrowed Capital
- The biggest disadvantage of borrowed capital is that company has to pay interest on borrowed amount whether it’s making profits or losses in the business. In times of profit, there is no issue but when the company is making losses than this interest payment can be burdensome and may put the company in financial jeopardy.
- Another disadvantage is that the leverage factor because as long as business is doing good than leverage helps the company in generating more profits but once the business goes down and company make losses than leverage can be disastrous and history is filled with examples where the company has become insolvent or bankrupt due to high amount of debt in the balance sheet of the company.
- Another disadvantage of borrowed capital is that sometimes borrowers or creditors puts restrictions and conditions regarding the end use of funds which may lead to problems for the owners of the company because having funds with restrictions is like playing a football match with tied legs. Hence in a way, borrowed funds with the restriction on the use of funds do more harm than good for the company.
As one can see from the above that borrowed capital has benefits as well as limitations and any company thinking of borrowing capital for business should carefully analyze advantages as well as disadvantages and then take the decision regarding whether to take borrowed capital or not for the business.