What is Debt Financing?
Debt means borrowing money, and debt financing mean borrowing money without giving away your ownership rights. Debt finance means having to pay both the interest and the principal at a certain date; however, with strict conditions and agreements, if debt conditions are not met or are failed, then there are severe consequences to face.
Debt can be either a loan form or in the form of the sale of bonds; however, they do not change the conditions of the borrowings. Usually, the interest rate and the maturity or the payback date of debt borrowings are fixed or pre-discussed. The payback of the principals can be done in full or in part payments as agreed upon in the loan agreement. The lender of the money can claim his money back as per the agreement. And hence lending money to a company is usually safe, for you will definitely get your principal back along with the agreed interest above the same.
Debt financing can be both secure and unsecured. Security is usually a guarantee or an assurance that the loan will be paid off; this security can be of any type. In contrast, some lenders will lend you money based on your idea or your name or brand goodwill. Various types of security can be offered to avail debt finance based on security, or debt finance can be availed as a different type of goodwill of your name or your brand. Various types of security can be offered to avail debt finance based on security, or debt finance can be availed as a different type of unsecured loans as well.
What is Equity Financing?
The company always needs cash or additional cash to grow. These funds can be raised either by debt or equity financing. Now that you know about debt financing let us explain equity financing. Unlike debt financing, equity financing is a process of raising funds by selling the company’s stocks to the financer.
Finance is required for every business and in every stage of business, be it the startup or the company’s growth. The selling of stocks gives the company ownership interest to the financer. The proportion of ownership given to the financer depends on the amount invested in the company.
Equity Financing is another word for ownership in a company. Usually, companies like equity financing because the investor bears all the risk in case of business failure. The investor is also at a loss. However, the loss of equity is the loss of ownership because equity gives you a say in the company’s operations and mostly in the company’s difficult times.
Besides just the ownership rights, the investor also gets some claims of future profit in the company. The satisfaction of equity ownership comes in various forms; for example, some investors are happy with the ownership rights; some are happy with the receipt of dividends. In contrast, some investors are happy with the appreciation of the share price of the company.
There are various reasons and requirements for investing in an organization. Look at the notes below to learn more.
|Base of Difference||Debt||Equity|
|Meaning||Funds borrowed from financiers without giving them ownership rights;||Funds raised by the company by giving the investor’s ownership rights;|
|What is it for the company?||Debt finance is a loan or a liability of the company.||Equity finance is an asset of the company, or the companies own funds.|
|What does it reflect?||Debt finance is an obligation to the company.||Equity finance gives the investor ownership rights.|
|Duration||Debt finance is comparatively short term finance.||Equity, on the other hand, is longterm finance for the company.|
|Status of the lender||Debt financier is a lender to the company.||The shareholder of the company is the owner of the company.|
|Risk||Debt falls under low-risk investments.||Equity falls under high-risk investments|
|Types of financing||Debt financing can be categorized by Term Loan, Debentures, Bonds, etc.||Shares and Stocks can categorize equity.|
|Investment Payoff||Lenders get paid to interest over and above the principal amount financed.||Shareholders of the company get a dividend on the ratio of shares held / profit earned by the company.|
|Nature of the return||The interest payable to the lenders is fixed and regular and also mandatory.||Dividend paid to the shareholders is variable, irregular as it completely depends on the profit earnings of the company.|
|Security||Security is required to secure your money. However, several companies raise funds even without giving security.||No security is required in case of investing in a company as a shareholder as the shareholder gets ownership rights.|
Advantages and Disadvantages of Debt Financing
- Debt financing does not give the lender ownership rights in your company. Your bank or your lending institution will not have a right to tell you how to run your company, and hence that right will be all yours.
- Once you pay back the money, your business relationship with the lender ends.
- The interest you pay on loans is after the deduction of taxes.
- You can choose the duration of your loan. It can either be long term or short term.
- If you choose a fixed-rate plan you the amount of the principal and the interest will be known, and hence you can plan your business budget accordingly.
- You have to pay back the money in a specific amount of time
- Too much of a loan or debt creates cash flow problems which create trouble in paying back your debts.
- Showing too much of debt creates a problem in raising equity capital as debt is considered high-risk potential by investors, and this will limit your ability to raise capital.
- Your business can fall into big crises in case of too much debt, especially during hard times when the sales of your organization fall.
- The cost of repaying the loans is high, and hence this can reduce the chances of growth for your company.
- Usually, the assets of a company are held collateral to the lending institution to get a loan as security of repaying the loan.
Advantages and Disadvantages of Equity Financing
- The risk here is less because it is not a loan, and it need not be paid back. Equity financing is a good way of financing your business if you cannot afford a loan.
- You actually collect a network of investors, which increases the credibility of your business.
- An investor does not expect immediate returns from his investment, and hence it takes a long term view of your business.
- You will have to distribute profits and not pay off your loan payments.
- Equity financing gives you more cash in hand for expanding your business.
- In case the business fails, the money need not be repaid.
- You can end up paying more returns than you might pay for a bank loan.
- You may or may not like giving up the control of your company in terms of ownership or share of profit percentage with investors.
- It is important to take the consent or consult your investors before making a big or a routine decision, and you may not agree with the decision given.
- In the case of a huge disagreement with the investors, you might have only to take your cash benefits and let the investors run your business without you.
- Finding the right investors for your business takes time and effort.
When it comes to financing, a company will choose debt financing over equity, for it would not want to give away ownership rights to people; it has the cash flow, the assets, and the ability to pay off the debts. However, if the company does not qualify in these above aspects of meeting up to the great risk of lenders, they will prefer choosing equity finance over debt.
When you talk about an example, we would always give you the example of a startup because these companies have very limited assets to keep as a security with the lenders. They do not have a track record, are not profitable, they have no cash flow. And hence debt financing gets extremely risky. It is where equity financing steps in as investors can bear the risk, for they are looking forward to huge returns if the company succeeds.
On the other hand, a company with too much of existing debts may not be able to get more loans or advances from the market. This is as good as being shorn of a mortgage loan for a simple reason that the banks cannot take the risk of funding a company with weak cash flow , a poor credit history along with too much of existing debt. This is where the company should look for investors.
It is extremely important to strike a balance between a company’s debt and equity ratios to make sure your company makes appropriate profits. Too much debt can lead to bankruptcy, whereas too much equity can weaken the existing shareholders, which can harm the returns.
Hence, the key is striking a balance between the two to maintain the company’s capital structure. Well, the ideal debt/equity ratio is 1:2, where equity always needs to be twice the organization’s debt. Double the quantity of equity is an assurance that the company can easily cover all the losses born by the company efficiently.
As we all know, it is extremely important to keep and maintain the balance of everything. Maintaining an appropriate balance between financing your company can lead to appropriate profit-making. The same goes for business and investments.