By:- Vivek Shivakumar
What are Debt and Equity?
Debt and equity are the external sources of finance for a business. When a business needs a lot of money for an expansion of projects or for reinvestment and improving their products, services, or deliverables, they go for equity and debt.
Debt Financing
When a firm raises money for capital by selling debt instruments to investors, it is known as debt financing. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid on a regular schedule. Businesses opt for debt for two main reasons. Firstly, if the business has gone through the route of equity, then they would take a portion of the debt to create leverage. Secondly, many businesses don’t want to go through the complicated process of IPO and that’s why they opt for a route to take debt from the banks or financial institutions.
Equity Financing
Equity financing is the process of raising capital through the sale of shares in a company. With equity financing comes an ownership interest for shareholders. Equity financing may range from a few thousand dollars raised by an entrepreneur from a private investor to an initial public offering (IPO) on a stock exchange running into the billions. Equity is helpful for those who would like to go public and sell the shares of the company to individuals. To conduct an IPO, a company needs to bear various costs; but the end result is most cases are helpful.
Risks of Debt Financing:
If a company fails to generate enough cash, the fixed-cost nature of debt can prove too burdensome. This basic idea represents the risk associated with debt financing.
Example
Provided a company is expected to perform well, you can usually obtain debt financing at a lower effective cost.
For example, if you run a small business and need $40,000 of financing, you can either take out a $40,000 bank loan at a 10 percent interest rate, or you can sell a 25 percent stake in your business to your neighbour for $40,000.
Suppose your business earns a $20,000 profit during the next year. If you took the bank loan, your interest expense (cost of debt financing) would be $4,000, leaving you with $16,000 in profit.
Conversely, had you used equity financing, you would have zero debt (and as a result, no interest expense), but would keep only 75 percent of your profit (the other 25 percent being owned by your neighbor). Therefore, your personal profit would only be $15,000, or (75% x $20,000).
From this example, you can see how it is less expensive for you, as the original shareholder of your company, to issue debt as opposed to equity. Taxes make the situation even better if you had debt since interest expense is deducted from earnings before income taxes are levied, thus acting as a tax shield (although we have ignored taxes in this example for the sake of simplicity).
Of course, the advantage of the fixed-interest nature of debt can also be a disadvantage. It presents a fixed expense, thus increasing a company’s risk. Going back to our example, suppose your company only earned $5,000 during the next year. With debt financing, you would still have the same $4,000 of interest to pay, so you would be left with only $1,000 of profit ($5,000 — $4,000). With equity, you again have no interest expense, but only keep 75 percent of your profits, thus leaving you with $3,750 of profits (75% x $5,000).
However, if a company fails to generate enough cash, the fixed-cost nature of debt can prove too burdensome. This basic idea represents the risk associated with debt financing.
Debt vs Equity Infographics
There are many differences between debt and equity, but both serve the same purpose i.e. to help the company expand on their growth and endeavors. Here are the most important differences between debt and equity –
Essentially you will have to decide whether you want to pay back a loan or give shareholders stock in your company. The following table discusses the advantages and disadvantages of debt financing as compared to equity financing.
Advantages of Debt Compared to Equity
- Because the lender does not have a claim to equity in the business, debt does not dilute the owner’s ownership interest in the company.
- A lender is entitled only to repayment of the agreed-upon principal of the loan plus interest, and has no direct claim on future profits of the business. If the company is successful, the owners reap a larger portion of the rewards than they would if they had sold stock in the company to investors in order to finance the growth.
- Except in the case of variable rate loans, principal and interest obligations are known amounts which can be forecasted and planned for.
- Interest on the debt can be deducted on the company’s tax return, lowering the actual cost of the loan to the company.
- Raising debt capital is less complicated because the company is not required to comply with state and federal securities laws and regulations.
- The company is not required to send periodic mailings to large numbers of investors, hold periodic meetings of shareholders, and seek the vote of shareholders before taking certain actions.
Disadvantages of Debt Compared to Equity
- Unlike equity, debt must at some point be repaid.
- Interest is a fixed cost which raises the company’s break-even point. High interest costs during difficult financial periods can increase the risk of insolvency. Companies that are too highly leveraged (that have large amounts of debt as compared to equity) often find it difficult to grow because of the high cost of servicing the debt.
- Cash flow is required for both principal and interest payments and must be budgeted for. Most loans are not repayable in varying amounts over time based on the business cycles of the company.
- Debt instruments often contain restrictions on the company’s activities, preventing management from pursuing alternative financing options and non-core business opportunities.
- The larger a company’s debt-equity ratio, the more risky the company is considered by lenders and investors. Accordingly, a business is limited as to the amount of debt it can carry.
- The company is usually required to pledge assets of the company to the lender as collateral, and owners of the company are in some cases required to personally guarantee repayment of the loan.
References
https://www.investopedia.com/ask/answers/05/debtcheaperthanequity.asp
https://www.wallstreetmojo.com/debt-vs-equity/
https://smallbusiness.findlaw.com/business-finances/debt-vs-equity-advantages-and-disadvantages.html
