Equity Financing Vs. Debt Financing: What’s The Difference?

To raise capital for business activities, firms mainly have two possible types of financing: debt financing and equity financing. In debt financing, the cost can be defined as the interest expense paid by the company to service its debt. However, when it comes to equity financing, capital cost refers to the claims on earnings that are provided to the shareholders for their stake in the business.

Equity Financing

Equity Financing refers to the process of raising capital by selling shares. Generally, equity financing comes with ownership interest for the shareholders. Equity financing might range from a few hundred dollars raised by the entrepreneur from an investor to an IPO (Initial Public Offering) on a stock exchange running into millions or billions.

Equity financing is largely determined by ownership in a firm. In most cases, big brands prefer equity financing due to the fact that the investors bear the risk if the business fails. Nevertheless, a loss of inequity is a loss of ownership since equity means you can still say what happens in the company.

Besides ownership, the investors can also claim profits made by the company. Satisfaction with equity financing comes in different forms. Some investors might be happy with receiving dividends while others might be happy with owning part of the company.

Debt Financing

When a company raises funds from the capital through the sale of debt instruments to investors that’s called debt financing. As a result, the institutions and individuals who’ve lent money to the company in question become the creditors. The company promises that the interest and principal on the acquired debt will be repaid on a consistent schedule.

Debt financing can be both unsecured and secure financial. The security is usually an assurance or guarantees that the loan will be paid off ultimately. Keep in mind that security can be of any kind. Some lenders will give you a loan based on the goodwill of your brand or name or even on your idea. Different types of security could be offered to avail the debt finance based on the security.

Example

If a company is expected to perform exceptionally well, the management can get debt financing at a lower cost.

For instance, if you operate a small business and only need $60,000 financing, you can obtain a $60,000 bank loan at a 10% interest rate or you could sell a 20% stake in your business to an investor for $60,000.

If the business can make a $10,000 profit in the same year. If you had taken a bank loan, the interest expense will be about $6,000, which leaves you with $4,000.

On the other hand, if you had instead used equity financing, you could have no debt, which means no interest expense, but you’d only keep 80% of the profit (the remaining 20% is owned by the investor). So, your profit will only be $8,000.

From this illustration, you can clearly see how it’s less costly for you, as the main shareholder of the firm, to equity as opposed to the debt issue. Your profit would even be greater if you had debt interest expense that’s deducted from the earnings before the income tax is levied, hence acting as the tax shield.

Technically speaking, the advantage of a fixed interest debt could also be detrimental. This is because it presents a fixed expense and ultimately increases the firm’s risk. If we can go back to the example above if the company only earned $5000 during the year. When it comes to debt-equity financing, you could still have to pay higher interest on debt financing.

Bottom Line

With regards to financing, a firm will prefer debt financing to equity financing mainly because it doesn’t want to give away any ownership rights to the investors, ability to clear off the debts, the assets, or have the cash flow. Nevertheless, if a company doesn’t have quality in these aspects, then it would be better off choosing equity financing over debt financing.

It’s important for the management to strike a balance between the equity and debt ratios of a company to ensure the company makes ideal profits. Too much debt could lead to bankruptcy, while lots of equity could weaken the current shareholders, and ultimately impact the returns.

The most important thing is to strike a balance between equity and debt finance to properly maintain the company’s capital structure. The ideal equity/debt ratio is 2:1 because equity should always be twice the debt of the company.

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