Merits and demerits of capital finance
Equity financing means the owner, own funds and finances. Small-scale businesses, such as partnerships and sole proprietorships, are typically owner-operated through their own finances. Stock companies operate on the basis of capital shares, but their management is different from that of shareholders and investors.
Equity Finance Merits:
The following are the merits of equity finance:
(i) Of a permanent nature: Equity financing is permanent in nature. There is no need to return it unless liquidation occurs. The shares once sold remain in the market. If any shareholder wants to sell those shares, he can do so on the stock exchange where the company is listed. However, this will not pose any liquidity problem for the company.
(ii) Solvency: Equity finance increases the solvency of the business. It also helps to increase the financial situation. In times of need, the share capital can be increased by inviting offers from the general public to subscribe for new shares. This will allow the company to successfully face the financial crisis.
(iii) Creditworthiness: High-equity financing increases creditworthiness. A business in which equity financing has a high proportion can easily get a loan from banks. Unlike those companies that are under a serious debt load, they are no longer attractive to investors. A higher proportion of equity financing means that less money will be needed to pay interest on loans and finance charges, so much of the profit will be distributed to shareholders.
(iv) Without interest: No interest is paid to any third party in case of equity financing. This increases the net income of the business that can be used to scale up operations.
(v) Motivation: As in equity finance, all profits stay with the owner, motivating them to work harder. The sense of inspiration and care is greater in a business that is financed with the owner’s money. This keeps the entrepreneur aware and active to seek out opportunities and make a profit.
(vi) Without Danger of Insolvency: As there is no borrowed capital, no repayment is required on any strict schedule. This frees the entrepreneur from financial worries and there is no danger of insolvency.
(vii) Settlement: In the event of dissolution or liquidation, there is no third party charge on the assets of the company. All assets remain with the owner.
(viii) Capital Increase: Corporations may increase both the issued and authorized capital after meeting certain legal requirements. Therefore, in times of need, financing can be obtained by selling additional shares.
(ix) Advantages of the macro level: Equity finance produces many macro-level and social benefits. First reduce the items of interest in the economy. This turns people into a tree of financial worries and panic. Second, the growth of public limited companies allows a large number of people to participate in their profits without taking an active part in their management. Therefore, people can use their savings for monetary rewards for a long time.
Equity Finance Demerits:
The following are the demerits of capital finance:
(i) Decrease in Working Capital: If most of the business funds are invested in fixed assets, then the business may experience a shortage of working capital. This problem is common in small-scale companies. The owner has a fixed amount of capital to start with and most of it is consumed in fixed assets. This leaves less to cover current business expenses. In large-scale business, financial mismanagement can also lead to similar problems.
(ii) Difficulties in making periodic payments: In the case of capital financing, the entrepreneur may experience problems making regular and recurring payments. Sales revenue can sometimes drop due to seasonal factors. If sufficient funds are not available, it will be difficult to meet short-term liabilities.
(iii) Higher Taxes: Since no interest is to be paid to any third party, the company’s taxable income is higher. This translates into a higher incidence of taxes. In addition, there is double taxation in certain cases. In the case of corporations, all income is taxed before any appropriation. When dividends are paid, they are taxed again with the income of the recipients.
(iv) Limited Expansion: Due to equity financing, the entrepreneur cannot increase the scale of operations. Business expansion needs huge financing to set up a new plant and capture more markets. Small-scale companies also do not have any career guidance available to expand their market. There is a general tendency for owners to try to keep their business within that limit in order to maintain affective control over it. As the business is financed by the owner himself, he is very obsessed with the possibilities of fraud and embarrassment. These factors hinder business expansion.
(v) Lack of research and development: In a business that is run solely on equity financing, there is a lack of research and development. Research activities are time consuming and large funding is needed to come up with a new product or design. These research activities are undoubtedly expensive, but eventually, when their results are released to the market, huge revenues are made. But the problem arises that if the owner uses his own capital to finance long-term research projects, he will have trouble meeting short-term obligations. This factor discourages investment in research projects in a company financed by capital.
(vi) Delay in Replacement: Companies operating with capital financing face problems when modernizing or replacing capital equipment when it wears out. The owner tries to use the current equipment as long as possible. Sometimes he can even ignore the deteriorating quality of production and continue to use old equipment.