Debt and Equity finance are the most common ways of raising capital for a Business. These methods play crucial roles in the financing of a Company. Each one has different advantages and disadvantages, meaning one may be more or less suited for use under certain circ*mstances and certain market conditions.
What is Debt Finance?
Raising funds through debt finance means borrowing money from sources external to the Company, such as banks or other financial institutions. It works in the following way:
- Loan or bond issue: The Business borrows a specific amount of money from a bank or financial institution following an agreement over the loan term, interest, repayment sums and amount.
- Interest payments: The Business pays back the borrowed sum in increments, alongside interest on the borrowed amount.
- Principal repayment: Finally, the Business repays the entire borrowed amount, and the loan is discharged.
Advantages of Debt Finance:
- Tax deductibility: Interest payments can be tax deductible, reducing the overall cost of the borrowing.
- Retained Control: The shareholders of the company maintain control of the operations and decision making.
- Simple financial planning: If the loan is on fixed interest terms, it can mean that with a repayment schedule, long term financial planning and budgeting can be made simple.
Disadvantages of Debt Finance:
- Interest Costs: In order to be able to borrow, the banks or financial institutions will require the business to pay interest on top of the payment. In the current economic climate, with Bank of England Interest rates at 5.25%, these interest costs can be substantial.
- Risk of Default: Should the Business fail to repay an instalment, it may be that the full amount becomes due. As a right to demand a repayment of the full amount plus all accrued unpaid interest (and any other amounts due) by the borrower in the event of default, is not considered a penalty under English law, is a very real possibility.
- Leverage risk: High debt levels can strain the financial health of the Business. As hom*ogeneous with all leveraged risk, if the business goes well, then all is well. However if the Business goes badly, rather than simply ‘going broke’ the Business has actually gone further than that and gone negative.
What is Equity Financing?
Equity financing consists of selling ownership of the Company to investors. This is done through the sale of shares in the Company, done in the following way:
- Equity issuance: The Company sells shares (typically of common or preferential) to investors.
- No Repayment: The Company receives cash in return for the shares. This raises capital for the Company.
- Shareholders: The purchasers of the shares are now shareholders of the company and have the rights associated with the shares they purchased (typically voting and/or potential dividends)
Advantages of Equity finance:
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- No repayment pressure: As there is no loan to be repaid, financial stress on the company is eased.
- Shared risk: The purchasers of the Company share the risk, as without the Company doing well, their equity is worthless.
- Expertise and Networks: By introducing equity investors to the Company it can mean that expertise and connections are introduced, which can help the Company thrive.
Disadvantages of Equity finance:
- Dilution of ownership and subsequent loss of control: By selling shares in the Company, the overall portion of ownership has been diluted, meaning that the original owners of the Company own less of the Company they set up. Alongside that, these new shareholders will want a say in the company decision making, potentially further constricting the owners.
- Potential Dividend expectation: If the profits of the Company increase, the Shareholders will potentially demand dividends, as a way of returning their original investment.
Which is better?
There is no clear answer as to which is better, as each method of raising capital may be more suitable for different situations.
Debt Financing can be more suitable for short term needs (e.g working capital) and for established Businesses who can be sure they can meet the financial commitments.
Equity Financing can be more suited for startups or growth-oriented Companies where cash flow may not be certain or expected for a while.
FAQs
Debt financing refers to taking out a conventional loan through a traditional lender like a bank. Equity financing involves securing capital in exchange for a percentage of ownership in the business.
Why is debt better than equity? ›
All else being equal, companies want the cheapest possible financing. Since Debt is almost always cheaper than Equity, Debt is almost always the answer. Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders' expected returns are lower than those of equity investors (shareholders).
What is the difference between equity based financing and debt financing? ›
Debt financing involves the borrowing of money, whereas equity financing involves selling a portion of equity in the company. The main advantage of equity financing is that there is no obligation to repay the money acquired through it.
What are the pros and cons of debt financing? ›
Pros of debt financing include immediate access to capital, interest payments may be tax-deductible, no dilution of ownership. Cons of debt financing include the obligation to repay with interest, potential for financial strain, risk of default.
What is the main difference between debt and equity financing quizlet? ›
Debt financing raises funds by borrowing. Equity financing raises funds from within the firm through investment of retained earnings, sale of stock to investors, or sale of part ownership to venture capitalists.
Is debt or equity financing riskier? ›
Debt financing is generally considered to be less risky than equity financing because lenders have a legal right to be repaid. However, equity investors have the potential to earn higher returns if the company is successful. The level of risk and return associated with debt and equity financing varies.
What is a good debt to equity ratio? ›
Generally, a good debt ratio is around 1 to 1.5. However, the ideal debt ratio will vary depending on the industry, as some industries use more debt financing than others.
Which is more safe debt or equity? ›
Generally, debt funds are considered safer than equity funds because they primarily invest in fixed-income securities with lower volatility. However, the level of safety depends on the credit quality and maturity of the underlying securities.
What is more expensive, debt or equity financing? ›
Equity financing is thought to be more expensive in the long run than debt financing. This is because investors seek a larger rate of return than lenders. Investors take on a lot of risks when backing a business, therefore they seek a higher return.
Is a bond a debt or equity? ›
The main types of financial securities are bonds and equities. Bonds are debt instruments. They are a contract between a borrower and a lender in which the borrower commits to make payments of principal and interest to the lender, on specific dates.
Debt financing can be difficult to obtain. However, for many companies, it provides funding at lower rates than equity financing, particularly in periods of historically low-interest rates. Another advantage to debt financing is that the interest on the debt is tax-deductible.
Which is an advantage of equity financing over debt financing? ›
The most important benefit of equity financing is that the money does not need to be repaid. However, the cost of equity is often higher than the cost of debt.
Does equity financing have to be repaid? ›
With equity financing, there is no loan to repay. The business doesn't have to make a monthly loan payment which can be particularly important if the business doesn't initially generate a profit. This in turn, gives you the freedom to channel more money into your growing business.
Why use equity instead of debt? ›
It allows you to avoid debt, provides working capital, brings industry knowledge and expertise, and offers the potential for significant funding. Consider equity financing if you are looking for a financing option that aligns with your growth goals and provides additional resources for your business.
Why is equity financing high risk? ›
The main disadvantage to equity financing is that company owners must give up a portion of their ownership and dilute their control. If the company becomes profitable and successful in the future, a certain percentage of company profits must also be given to shareholders in the form of dividends.
Is an equity loan risky? ›
Despite their advantages, home equity loans come with risks: You could lose your home if you miss payments, owe more than your home's worth, and your credit score could suffer.
When to use equity? ›
Home equity financing offers more money at a lower interest rate than credit cards or personal loans. Some of the most common (and best) reasons for using home equity include paying for home renovations, consolidating debt and covering emergency or medical bills.
What are five differences between debt and equity financing? ›
Debt finance requires no equity dilution, but the business must “pay” for this benefit via interest on top of the initial sum. Equity finance doesn't require the payment of any interest, but it does mean sacrificing a stake in the business and ultimately a share of future profits.
What are the drawbacks of a debt consolidation loan? ›
The potential drawbacks of debt consolidation include the temptation to rack up new debt on credit cards that now have a $0 balance and the possibility of hurting your credit score with late payments. Also note that the best personal loans go to consumers with very good or excellent credit, so not everyone can qualify.
What is the difference between debt and equity funds? ›
Equity mutual funds are equity-oriented mutual funds that invest in shares, bonds, and other securities. Debt mutual funds invest primarily in debt securities such as government and corporate debt. There are many advantages to investing in equity mutual funds over debt mutual funds.
Equity financing involves selling shares of ownership in the company while debt financing does not. Equity financing often involves paying interest while debt financing does not.
Which of the following is a difference between debt and equity capital? ›
Equity capital is the funds raised by the company in exchange for ownership rights for the investors. Debt Capital is a liability for the company that they have to pay back within a fixed tenure.
What is the difference between debt financing and equity financing brainly? ›
Equity financing means selling shares and part of the ownership in a company, sharing risks and rewards with the new investors, while debt financing involves borrowing funds, committing to paying interest, and retaining full control and ownership.
