Many times, the secret to the financial success of a business is unknown to the general public. It is difficult to figure out the modus operandi that was involved in financing a business. Getting to know the processes involved in a business’ finances will give a clear idea of how businesses operate and whether or not they are doing well. Here, I will share the differences between debt and equity financing; its merits and demerits, and give a fair idea between the two ways of financing businesses.
Investopedia defines debt as an amount of money borrowed by one party from another. Debt financing is the running of a business or an entity with money borrowed from another party. This can either be from an individual or an institution and it is to be repaid with interest. On the other hand, equity is defined by Investopedia as a stock or any other security representing an ownership interest. In accounting, equity is the net value between the value of assets and the value of liabilities. Equity can also be gained by selling interests in the business. With a sole proprietorship business, it’s referred to as owner’s equity while it is shareholder’s equity in the corporate world. Equity financing is the continual spending of what is left from the deductions of liabilities from assets to run the business. It is the “operationalization” of a business with its own net value, whether by owners or shareholders.
These are the merits of debt over equity financing;
i. Interest to be paid on the money borrowed can be deducted on the company’s tax return, lowering the actual cost of the loan the company took.
ii. A lender does not have a claim to equity in the business, as such, debt does not dilute the owner’s ownership interest in the company.
iii. A lender is only entitled to repayment of the agreed-upon principal of the loan in addition to interest, and has no claim on profits of the business later on. If the company is profitable, the owners reap a larger portion of the rewards than they would if they had sold stock in the company to investors.
iv. Interests on loans can be forecasted, except in the case of variable rate loans. This means the principal and interest obligations are known amounts of which the debtor can analyse, forecast, and plan for even before going for the loan.
v. Raising debt resources is less complicated as compared to equity because the company is not required to comply with state securities laws and regulations.
vi. The company is not pressured to periodically send records to large numbers of investors, hold periodic meetings of shareholders, and seek the vote of shareholders before taking certain actions.
Nevertheless, equity seems to be more appropriate in financing a business than debt, for the following reasons:
i. Unlike equity, debt must be paid at some point.
ii. Many companies have defaulted repayment of their loans in the agreed time frame and this comes with its unique consequences.
iii. 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 have large amounts of debt often find it difficult to grow because of the high cost of servicing the debt.
iv. 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.
v. Debt instruments often contain restrictions on the company’s activities, preventing management from pursuing alternative financing options and non-core business opportunities.
vi. The larger a company’s debt-equity ratio, the riskier they are in the eyes of investors. Usually, a business’ ability to receive a loan is limited by how high the debt-equity ratio is.
vii. Companies are usually required to pledge their assets to the lender as collateral and business owners are, in some cases, required to personally guarantee repayment of the loan.
There are many more factors to differentiate between debt and equity financing. Each module comes with it pros and cons. Others believe that debt is better off to be used in financing a business’ operations because of its effect on the value of the loan during tax returns, while others believe equity is more preferred because it boosts investor confidence and creates a good image for the business to the world. It is therefore important that even lay persons figure out how businesses are financed and its effects on the value of the business.
Written By: Mr. Ebenezer Mensah