Capital is necessary for the operation of a business or corporation. Companies primarily have two types of financing options for raising funds for commercial needs: Equity financing and Debt financing. Though each has its peculiarity, most businesses utilize a combination of debt and equity financing.
Insolvency denotes the inability to fulfil financial obligations. Such a state can be presumed to be reached due to the failure of a company to maximise its financial options for its betterment.
This article aims to analyse the relationship between Debt and Equity financing to understand its workings, and which best prevents a company from becoming insolvent.
INSOLVENCY IN A COMPANY
The term Insolvency connotes a circumstance in a company, or it relates to an individual when financial liabilities supersede assets such that Creditors cannot be settled.
Insolvency is the failure of a company to fulfil its financial obligations. Section 572(a)(b)(c) of the Companies and Allied Matters Act, 2020 and Section 408(d) of Bankruptcy and Insolvency (Repeal and Re-enactment) Act, 2016, describes Insolvency as the failure of firms to recompense financial obligations particularly the creditors by an assignment which the firm owes a sum above N2oo,000.00.
By the clear provisions of Section 572 (a) of the Companies and Allied Matter Act, the creditor must give notification of its claims to the firm at its head office demanding the sum which is outstanding for three (3) weeks and after the expiration of such period, where the firm or company fails to or declines to disburse the unpaid amount to the approval of the creditor or lender, such a company is deemed to be insolvent. The clear wordings of Section 572 (a) are replicated for a better understanding;
“A company is deemed to be unable to pay its debts if— (a) a creditor, by assignment or otherwise, to whom the company is indebted in a sum exceeding N200,000, then due, has served on the company by leaving it at its registered office or head office, a demand under his hand requiring the company to pay the sum due, and the company has for three weeks thereafter neglected to pay the sum or to secure or compound for it to the reasonable satisfaction of the creditor”
There are essentially two techniques for determining Insolvency: Equity-based insolvency and Balance-sheet-based insolvency. In the equity sense, insolvency refers to a debtor’s inability to pay his debts when they fall due in the normal course of business. According to the balance-sheet approach, insolvency occurs when the debtor’s entire liabilities exceed his total assets.
Insolvency is not the same as bankruptcy. Bankruptcy is a legal status of an insolvent person or an organization, as well as an individual who cannot pay up the debts they owe to Creditors. Insolvency may be distinguished from bankruptcy to the extent that in Nigeria, a person unable to pay his debts cannot declare himself bankrupt except by the Court, after considering a petition brought before it for that purpose. It is only the Court that has the power to declare an individual bankrupt.
Also, in some jurisdictions, the term Bankruptcy is reserved for individuals with the inability to pay debts owed to creditors while insolvency is used for companies unable to pay debts owed.
We shall now consider the financing options; debt and equity available to a company.
Getting a loan or a mortgage is the most popular type of debt financing. Debt finance is the process of lending money with the intention of repaying it with interest. The primary benefit of debt financing is that creditors do not own the company; instead, they are just entitled to the loan and the agreed interest rate. In the long run, this allows for a higher profit margin without having to sell the majority of the company to creditors.
Debt financing also enables a company to forecast expenses because loan payments do not fluctuate. This option of financing prevents and protects the control and ownership of a business to numerous shareholders especially when it is a small business. This is because once the loan is repaid, the relationship with and obligation owed to the financier is severed.
Advantages of Debt Financing
- The company retains ownership and control over business operations.
- The company is only liable to the creditors to the extent of debt owed.
- Debts are known expenses that can be easily forecasted by a company.
- In most jurisdictions, tax deductions are possible with debt financing.