Pros and Cons of Debt and Equity Financing

13-Aug-2007

When it comes to financing a business, most business people opt for a mix of both debt and equity financing as each has its own pros and cons in certain situations. There is no clear answer as to which of the two is the best. It will depend on the situation, size, profitability etc. of a company as well as the personal preferences of its owner(s).

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Debt financing involves the borrowing of money, usually from banks or other financial institutions, to set up or run a business. Equity finance, on the other hand, comes from investors who receive shares or a stake in the company in return for their investment. In this article we will outline the main advantages and disadvantages of each and advise on which is the best choice in certain situations.

Debt Financing: Pros and Cons   

The chief advantage of debt financing is that all the money comes from banks which do not expect to have any involvement or stake in your company. Debt financing is essentially a business loan, and your only responsibility is to keep up with repayments and keep to the terms agreed with the lender.

For any business person wishing to keep full control of their business, this is the ideal choice. There are no investors to keep happy, and no one else who has a say in the running and the direction of the company.  Another major advantage of debt financing is that loans can be used to buy equipment and other business assets while business profits are kept in the company. Also, any interest paid on loans can usually be deducted from tax.

However, there are also a number of disadvantages to debt financing. As with any loan, companies will have to show the bank how it is going to repay the money, and they'll have to secure the loan against an asset. The asset will usually be a premises or a piece of equipment that covers the value of the loan. In addition, a bank may require that some kind of personal asset is offered as security.

Financial institutions tend to favour companies that have good management, a reliable projected cash flow and good growth potential. Once the loan is secured, the business will then be obliged to service the debt, and they must ensure that payments are made on time each month, even in times of poor business. Loan repayments can quickly eat into profits, and any extra money earned by the success of the business might be going straight back to the banks.

Some debt financing is acceptable, but if a company relies too heavily on this kind of financing it may impact negatively on its credit rating and make it difficult for funds to be raised in the future.

Equity Financing: Pros and Cons   

There are a number of advantages to equity financing. Not least is the fact that contributions of this kind need not be paid back and neither the business nor any of its assets have to be guaranteed as security to obtain the investment. In addition, the money does not have to be paid back from your personal funds in case of bankruptcy, which is the case in debt financing.

If your business has equity then it will be looked on more favourably by investors, lenders and the Revenue Commissioners. A business that has secured equity will most likely have a sound plan and past success, which could convince a lender to give you a loan. A company that relies solely on debt financing does not look good.When it comes to the day to day running of the business, there will be more cash readily available as all profits can be kept within the company and none has to be spent on repaying debts.

However, equity financing has its disadvantages. The main drawback is that the owner has to give up a share of ownership rights and profits to equity investors. This is a big sacrifice of independence for any business owner. Also, any dividend payments to investors, if applicable, will not be tax deductable.

Conclusion

However, it is worth noting that it is best not to rely too heavily on debt financing as it is not looked on favourably by lending institutions or potential investors. It is important to maintain a favourable debt-to-equity ratio. If the ratio is too low, it may look as if the company?s profits are not being used wisely. You can calculate a company?s debt-to-equity ratio by dividing the business?s total debt by its total equity. A healthy debt-to-equity ratio is seen as being somewhere below 3:1 for most industries.  Both debt and equity financing has its own pros and cons, and it is up to the business owner to decide which is best for them.

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