A debt financed distribution can be an extremely lucrative strategy for company success. However, it may not be the right approach for all types of businesses. Taking out a loan can have huge financial complications, which makes it crucial to consider the different risks and implications involved.

In this article, we’ll be walking you through the pros and cons of implementing a debt finance distribution. Therefore, you’ll have a better idea if it’s the right plan of action for your company.

What Is Debt Financed Distribution?

Debt financed distribution is a financial strategy where a company or business borrows money to give back to its shareholders. Borrowing money has its advantages over raising money or using company profit or savings.

Generally speaking, there are two main ways to borrow money. The first way is by paying out special dividends to the shareholders. The second way is to buy back shares from shareholders.  This reduces the number of remaining shares (which in return, increases the share price value).

It doesn’t matter if you’re trying to finance a small business or a Fortune 500 company. Understanding the benefits and risks of a debt financed distribution is essential when defining your company’s financial strategy.

Why Do Companies Choose Debt Financed Distributions?

Borrowing money may not seem like a sound financial decision, especially if you’re sitting on a huge cash reserve. However, there are some major benefits to borrowing instead of dipping into the company savings.

It’s Tax Efficient

One of the main reasons to use debt financed distributions is for tax efficiency. Borrowed money and interest is often tax deductible. So by taking out a loan, companies can actually reduce their annual taxable income. And having a lower taxable income directly reduces how much money you will owe to the IRS.

It Increases Shareholder Value

When a company decides to buy back shares from shareholders, it can have a positive impact on the current value of the existing shares. This is because it reduces the number of total shares the company has, therefore increasing the value of each one. As a result, the Earnings Per Share (EPS) will be higher than before.

It Provides Flexibility

Having a large cash reserve or savings fund is important for any type of business. Running a company can be unpredictable, and it’s nice to have a fallback for unforeseen circumstances or sudden drops in revenue.

But besides helping with financial challenges, having extra cash is also good for growth. Perhaps the company decides to invest in a new product or put money toward research. Or maybe they want to acquire another business to open up a second office. Whatever the reason, it’s always good to have spare cash on hand.

Taking out a loan provides more flexibility. Instead of spending your hard-earned savings, you can save that for whatever future investments or needs your business may have.

It’s Great for the Company’s Reputation

Financial institutions only give out loans to companies that they know have the means to pay them back. So if you secure funds via debt financed distribution, this shows the market that you are confident about your profitability. After all, the company will need to make enough money in order to continue operations and pay back the debt.

With a strong brand reputation, it’s much easier for companies to secure money from investors.

It Has a Low Interest Rate

Despite what you may think, implementing a debt financed distribution can be relatively inexpensive. Interest rates fluctuate with the market, but it is possible for a company to secure a loan in a low-interest-rate environment. By doing so, they might not have a huge payback amount to the lender or bank so it won’t severely impact your financials.

Are There Risks Associated with Debt Financed Distributions?

As with any financial decision, there are certain risks associated with debt financed distributions. If this is something you are considering for your company, here are a few things to keep at the forefront of your mind.

There Is Still a Financial Risk

Taking out any type of loan (whether it’s as a company or as an individual) will always have its risks. Borrowing any amount of money will increase how much debt the company is in. While this is not necessarily a bad thing, it can still make your business high-risk. You are still required to pay back the loan even if revenue is low. This can make things complicated if you have a bad quarter or a rough year where you aren’t making as much.

It Can Worry Shareholders

Taking a large financial risk can be concerning for many shareholders. For companies that don’t have to dip into their cash reserve, it can be freeing to have more flexibility. But for others, taking a debt financed distribution can limit what the company is able to do financially.

For example, paying back borrowed funds with a high interest rate may need to come from your cash reserve anyway. That means fewer opportunities for investments and growth, which can worry some of your shareholders.

It Impacts Your Credit Rating

A large debt may temporarily lower your company’s credit rating. This can make securing funds in the future more difficult or more expensive. So, when taking out a loan, make sure it’s within a reasonable limit that your company is able to pay back. Having a healthy debt-to-equity ratio can prevent you from draining your savings or potentially going bankrupt!

Debt financed distributions can be a beneficial strategy for long-term success (especially if you’re looking to reduce your business tax). But there are associated risks that all businesses should understand before taking out a loan. By understanding the pros and cons of doing so, you can make the right financial decision for your company!