5 Benefits of Pecking Order Theory on Business Finance

Managing business finance is a challenging task for companies of all sizes. Business leaders must decide how to effectively fund their operations, growth, and investments. With various financing options available, such as equity, debt, and internal funds, it becomes crucial to determine the most advantageous way to secure capital. Selecting the right financing method can significantly impact a company’s profitability, risk profile, and overall financial health.

One effective solution is following the Pecking Order Theory. The term comes from the hierarchical behavior observed in poultry, where dominant birds peck those lower in the hierarchy to establish social order. In the context of business finance, the theory reflects a similar hierarchy, where companies prioritize their sources of financing in a specific order: internal funds first, then debt, and finally equity.

Here are the five main advantages of following Pecking Order Theory on business finance:

Lower Cost of Financing

Using internal funds first significantly reduces the need to pay interest or dividends to external financiers, which lowers the overall cost of financing. Internal funds come from retained earnings or existing cash reserves and do not incur the same costs as external funds. As a result, businesses can save on interest payments and avoid issuing new shares, which can be expensive due to underwriting fees and other associated costs.

When internal funds are insufficient, businesses may turn to debt as the next preferred source of financing. In this scenario, companies often look for affordable and manageable financing options. Take CreditNinja, for example. It’s an online alternative lender that offers competitive loan products that can help businesses secure the necessary funds without incurring high costs.

Reduced Risk of Financial Distress

Minimizing reliance on debt reduces the risk of financial distress and bankruptcy, as creditors have fewer obligations. When businesses use internal funds, they avoid the pressure of meeting regular interest payments and principal repayments associated with debt financing. This approach leads to a lower financial burden and a more stable financial position.

Additionally, by prioritizing debt over equity, businesses can take advantage of tax benefits since interest payments on debt are tax-deductible. However, maintaining a balance is crucial to prevent excessive leverage, which can heighten financial risk. Following the Pecking Order Theory also ensures that businesses only take on manageable debt levels, which reduces the likelihood of financial distress.

Maintaining Control and Ownership

By avoiding issuing new equity, companies can maintain greater control and ownership, preventing the dilution of shares. When a company issues new equity, existing shareholders’ ownership stakes are reduced, which can lead to a loss of control for the original owners. This dilution can be particularly concerning for small and medium-sized enterprises (SMEs) where ownership and control are often closely held.

Pecking Order Theory prioritizes internal funds and debt over equity, allowing businesses to preserve ownership and control. Using retained earnings or cash reserves means no new shareholders are introduced, and the decision-making power remains with the existing owners. Even when debt is used, control remains with the business owners, as lenders do not receive voting rights or influence over company decisions.

Signal of Financial Health

Following the Pecking Order Theory can signal to investors that a company is financially healthy, as it relies first on its own generated funds. When a company uses internal funds for financing, it indicates that the business generates sufficient cash flow and profits to fund its operations and growth. This self-reliance is a positive signal to investors and creditors, reflecting strong financial management and stability.

Moreover, businesses demonstrate prudent financial practices by avoiding excessive debt and equity issuance. Investors are more likely to trust and invest in companies with a disciplined financing approach. This trust can lead to better terms on future financing and a stronger overall reputation in the market.

Flexibility in Financial Planning

Using internal funds and manageable debt allows for greater flexibility in financial planning and responding to market changes. When businesses rely on their own resources and controlled levels of debt, they retain the ability to adapt quickly to new opportunities or challenges. This flexibility is crucial in a dynamic business environment where market conditions can change rapidly.

Internal funds provide a readily available source of capital that can be deployed without the delays associated with external financing. Manageable debt levels also ensure businesses are not overburdened with repayment obligations, allowing them to allocate resources more efficiently. This flexibility enables companies to take advantage of growth opportunities, invest in innovation, and respond to competitive pressures effectively.

Final Thoughts

The Pecking Order Theory aims to minimize the costs and risks associated with financing by prioritizing internal funds, debt, and equity. This approach benefits business finance by reducing expenses, maintaining control, and enhancing financial flexibility. Remember, however, that this list is not exhaustive. For more detailed information or personalized advice, consider further reading or consulting a professional.