Equity vs Debt Financing
Any firm, planning of starting up a new business or expanding into new business ventures, require adequate capital to do so. This is the point at which the company’s top managers are faced with a decision on their hands, as to whether they should go forward and obtain equity capital or consider the option of using debt capital. The implications of using either type of capital are different to each other in terms of the features of the form of financing, and the pros and cons attached to them. This article provides the reader a clear explanation of the differences between the two and the advantages and disadvantage of both forms of finance.
What is Equity Financing?
Equity financing is obtained by firms through gaining access to capital markets by listing the firm’s shares on a stock exchange. Equity capital can also be obtained through contributions by owners, business partners, venture capital firms or individual investors looking for a high growth investment opportunity. The main advantage of equity financing is that no payment needs to be made to the shareholders and funds can be retained for expansion, unless the company wishes to pay dividends. However, shareholders receive voting rights and are thereon able to contribute in the decision making of the business. Another significant disadvantage stems from the great risk of the company being subject to potential takeover by another entity through acquiring a majority stake in the company shareholdings. Furthermore, in order to list shares on a stock exchange, stringent laws and regulations must be complied with and this can be very costly and time consuming.
What is Debt Financing?
Debt financing is obtained through borrowing funds from banks, lending institutions and creditors. Debt financing is expensive as it entails an interest payment for the duration of the loan, and loans can be more complex in the sense that they require some form of collateral to be used in the event that the loan is defaulted on. Major advantages of debt financing are that interest payments are tax deductible and allow the company retain control of business operations within the firm. Disadvantages also include the possible failure of a firm to obtain the amounts of debt capital that they require because of their limited financial capacity to repay, and the requirement of a steady cash flow in order to make expensive interest payments. Furthermore, a company that holds excessive amounts of debt maybe at risk as the capital buffer may not be sufficient to cushion against unexpected losses.
What is the difference between Equity and Debt Financing?
Equity and debt financing are both forms of obtaining capital for a firm to start up a business or expansion of a business. The use of either, results in an inflow of funds to a firm, even though the implications of them are quite different. Debt financing entails a mandatory interest payment, which can be quite expensive and requires a steady cash inflow into a firm, whereas equity capital does not have any mandatory payments, and decisions regarding dividend payments are made solely on the manager’s re-investment decisions. Debt financing may not be available unless sufficient collateral is available to recover losses, and firms who may not have such assets to pledge may not be able to receive the full loan amount which may reduce growth prospects. Equity financing does not require any such collateral but entitles the shareholder a slice of the profits and decision making powers. On the other hand, debt financing allows shareholders complete control over operations and are tax deductible.
In a nutshell:
Equity Financing vs Debt Financing
• Debt and equity financing are the two ways that a firm may obtain the required funds for business activities.
• Debt financing requires a firm to obtain loans and pay large sums of interest, while equity financing is obtained by selling shares and paying dividends to shareholders.
• Selling shares to the public requires a listing on the stock exchange along with the many regulations and requirements that come with it, and once shares are sold shareholders have a voice in decisions made. On the other hand, debt financing provides managers with full decision making power.
• Excessive debt can be disastrous for a firm, whereas excessive equity may mean that the firm is not efficiently making use of its borrowing capacity.