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Debt vs Equity Instruments in Generating Cash for Business
Importance of Cash in Businesses
In businesses, cash is regarded as the asset with the highest significance due to its high liquidity and capacity to extinguish liabilities and obligations. This explains the rationale why primary users of general purpose financial statements place high emphasis on the cash levels of a company. However, in a world full of ups and downs, it is inevitable to encounter circumstances of having low level of cash balance despite constant demand for high liquidity. This may lead to a mismatch between the current cash available and the liabilities needed to pay and any other legal requirements. Hence, companies will search for alternatives that can increase or at the least keep constant the current cash levels of a company such as managing and protecting cash flows.
In practice, there are numerous means available to generate cash when needed. A company may choose to resort to receivable financing when it either sell its receivable or use it as collateral for a loan. However, a more famous option is to opt for investments either in debt or in equity.
Debt vs Equity Instruments
The two types of investment are more commonly known as “bonds” for debt investments and “stocks” for equity investments. There are two ways of acquiring cash in these types of investment. First, the company may opt to be the one issuing the stocks or the bonds to receive immediate cash in a relatively huge amount. On the other hand, the company may also opt to be the one who buys those stocks or bonds in order to receive contractual cash flows. This option results to gaining relatively small amount but in periodic intervals. However, the first option may seem to be infeasible in businesses operating with a smaller scale of activities, hence they choose the second option.
The question now will be, “Which one between bonds and stocks will generate more cash for the business?”
The Economics of Debt and Equity Investment: Factors to Consider
Companies need not to make hasty decisions especially when they were not able to weigh the pros and cons of each one of them. This holds significant in cases when there are people at stake (e.g. creditors and other stakeholders). In Economics, trade-off and opportunity costs are incorporated in the formulation of decisions to better gauge the feasibility. In addition, risks are being observed and estimated to make sound decisions. These economic concepts will enable managers to fully assess what to choose between debt and equity investments.
Trade Off and Opportunity Cost
In reality, we cannot really have it all. Chances are, we are faced with situations where we have to choose between several alternatives. By choosing one alternative among several options, all others will be trade-offs. All these have associated opportunity costs and managers should be able to assess all these. Sometimes, by foregoing something, we are losing more in the long-run. This is what the managers should avoid when choosing between debt and equity instruments.
Risk and Risk Management
It has been observed and statistically proven that stocks offers more rewards (in form of returns) compared to bonds, but the risk is just as much. On the other hand, bonds offer relatively small return, and hence may be considered immaterial in some degree and circumstances. Hence, economists believe that it is best to mix bonds with the stock portfolio. This option will balance the risk and returns, and thus results to a win-win situation. Also, companies may further lessen the risk by diversifying its stock portfolio. Managers may not allocate cash to purchase stocks from a single company, but rather to several companies with considerable stable or increasing financial performance.
Business decisions are indeed inevitable, and in most times, these entail heavy deliberation. This will involve weighing consequences through cost-benefit analysis and other methods possible. Furthermore, companies should consider implicit costs such as trade-offs and opportunity cost. These costs are often overlooked and hence not included in decisions. Hence, companies should use critical thinking and prior knowledge to determine these hidden costs. One of the examples where all these would be employed is when a company plans to invest on either bonds or stocks
Though it may sound so simple, investing is not simple business feat. This is due to the involvement of risks that can be highly detrimental to the business. Therefore, risk management strategies should be utilized so as to result to a more favorable outcome such as more cash inflow..
Choosing the Right Mix
In conclusion, it is highly advisable that companies manage risk by combining right mix of bonds and stocks. The mix depends on the discretion of the managers which then should be assessed based on its needs and structure. Furthermore, stocks should be diversified to spread the risks entwined with the stocks.