You may often hear that “debt is cheaper than equity”. Although there are advantages and disadvantages to each, business owners should carefully consider each option in detail before making a decision.
Here are a few points to consider when choosing a suitable form of financing for a business:
Debt financing – in its most general form it involves borrowing money (or loan) from another party, such as a bank or financial institution. The lender generally has a set term requiring repayment and charges interest on the loan principal outstanding.
Advantages to debt financing:
Lender generally has no say in how the borrower runs the business.
Interest on debt is tax deductible.
Debt repayments (principal and interest amounts) are known ahead of time as a repayment schedule is usually provided. This enables the borrower to budget and operate the business’ cash flows.
Disadvantages for debt financing:
Money must be paid back in set periods of time, effectively removing cash flow from the business that could have been used for operations.
There is usually a limit on the amount of money a company can borrow and is largely influenced by the amount of security that the company can offer. Security may include a percentage of certain assets, such as accounts receivable, inventory and fixed assets (e.g., equipment, land and building).
If too much debt is carried in the company this may deter potential investors, as the company will be viewed as being higher risk.
Equity financing – equity financing can involve many different shapes and forms. In a general context, equity financing involves an investor contributing capital into the company and in return, receives some form of ownership in the company (e.g., common or preferred shares).
Advantages to equity financing:
Some businesses may not have sufficient security to obtain a loan. Equity financing provides a viable alternative to obtaining capital.
In the short term equity financing may provide better cash flows to the business as there are no principal or interest payments required. This assumes there are negligible or no dividends required to be paid.
Disadvantages to equity financing:
Requirement to consult with the investor prior to making any significant decisions in the business or operations.
The investor receives a share in the company’s profits and future growth in the business, which may be well above the amounts that would have been paid to a lender for the same amount of capital received.
While there isn’t a single form of financing that will suit all businesses, depending on the company’s needs and abilities to obtain financing from different sources, a company can have a mix of debt and equity financing to support the company’s capital needs.