APPROPRIATE SOURCE OF WORKING CAPITAL 3: Equity or Debt?
Working Capital funds the cost of the labor & materials that go into the goods you sell (or the services you render) and what you use to pay for salaries, rent, office supplies, etc (i.e., your operating expenses).
The basic structure of your Income Statement determines whether you should fund your Working Capital from Equity or whether you can afford to fund it from Debt. If your Cost of Goods Sold eats into your Revenues by not more than 30%, and your Operating Expenses are more or less equal to your Cost of Goods Sold, you can afford to fund your Working Capital from Debt.
However, if you have funds readily available to cover not only your fixed assets but your operating expenses as well, it is better not to go into debt. In an economic downswing when customers spend less and markets shrink (as many businesses are experiencing today), the small business which has no debt to service will have the better chance of surviving until times get better.
Interest expense is beyond the control of the owner or manager. Most operating expenses can be downsized, interest cannot. Interest expense tends to grow with penalties & surcharges, until you reach a situation where you are able to service only the interest (and not have enough cash for the principal) and end up paying interest on interest. The most common cause of bankruptcies in small businesses is debt that has gone out of control.
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POSTED IN: Accounting Concepts, Best Business Practices, Cost of Goods Sold, Equity / Capital, Income Statements, Small Business Finance
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