Debt Financing Vs Equity Financing

Article byWallstreetmojo Team
Edited byPallabi Banerjee
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Debt Financing Vs Equity Financing?

The primary difference between Debt and Equity Financing is that debt financing is when the company raises the capital by selling the debt instruments to the investors. In contrast, equity financing is when the company raises capital by selling its shares to the public.

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Both the concepts have their own pros and cons, due to which the selection of either of them for financing will depend on the objective of the business, its financial strength, risk appetite, future expansion, and growth prospects., etc. Most companies go for a combined approach which provides a balance to the capital structure.

Debt Financing Vs Equity Financing Explained

Debt financing vs equity financing is a comparison that is very frequently made in the financial market while companies plan to raise capital. Therefore it is necessary to have a clear idea about both so that it is possible to understand and identify the method suitable for the purpose.

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In debt financing, the business raises capital by borrowing from lenders and to whom the business is liable to pay back the amount with interest. The lenders to get any ownership right in the management. Their income or return is the interest on the loan. Even during bankruptcy or liquidation, the lenders hace a priority in receiving their payment from the assets.

In equity financing, the company raises capital by issuing shares to the public, who become owners of the business upto the extent of the number of shares held by them. They have voting right in major company decisions. However they do not get any regular interest payment. The income source is the dividend that the company declares against each share, depending on its profitability levels. Unlike debt, equity does not put any immediate repayment obligation on the management of the company. Most entities go for a combination of debt and equity so that there is a proper balance in the capital structure. The risks and obligations of debt is compensated by the flexibility and safety of equity financing.

Companies like Pepsi’s debt to equity was at around 0.50x in 2009-1010. However, it started rising rapidly and is at 2.792x currently. What does this mean for Pepsi? How did its Debt to Equity Ratio increase dramatically? What is the key difference? How does it affect the Financial Strength of the company? This article will help in answering similar questions in detail about equity financing vs debt financing.

Debt to Equity Starbucks

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 goodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company's net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company's net identifiable assets from the total purchase price.read more 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 loansUnsecured LoansAn unsecured loan is a loan extended without the need for any collateral. It is supported by a borrower’s strong creditworthiness and economic stabilityread more 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 financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.read more  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 dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more. 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.

Example

Let us understand the concept of equity financing vs. debt financing with the help of a suitable example.

Analyzing Debt and Equity Financing of Oil & Gas Companies (Exxon, Royal Dutch, BP & Chevron)

Below is the Capitalization ratioCapitalization RatioCapitalization ratios are a set of ratios that assist analysts in determining how a company's capital structure will affect if an investment is made in the company. The debt-to-equity, long-term debt-to-market-cap, and total debt-to-market-cap ratios are all included.read more (Debt to Total Capital) graph of Exxon, Royal Dutch, BP, and Chevron.

Oil & Gas - Capitalization Ratio

Source: ycharts

We note that the Capitalization Ratio (Debt / Debt + Equity) has increased for most Oil & Gas companies. It means that the company has raised more and more debt over the years. It is primarily due to a slowdown in commodity (oil) prices affecting their core business, reducing cash flows and straining their balance sheet.

Debt vs Equity Financing - Example

Source: ycharts

Important points to note here are as follows –

  • Exxon capitalization ratio increased from 6.5% to 18.0% in 3 years.
  • BP’s capitalization ratio increased from 28.4% to 35.1% in 3 years.
  • Chevron’s capitalization ratio increased from 8.1% to 20.1% in 3 years.
  • Royal Dutch capitalization ratio increased from 17.8% to 26.4% in 3 years.

By comparing Exxon with its peers in debt financing vs equity financing examples, we note that the Exxon capitalization ratio is the best. Exxon has remained resilient in this down cycle and generates strong cash flows because of its high-quality reserves and management execution.

Infographics

The infographics given below show the differences is a concise and systematic format. It helps the reader to interpret and remember the points regarding equity financing vs. debt financing easily. Let’s see the top differences between debt vs. equity financing.

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Key Differences

The key difference section given below highlights the important point of differences between the two topics with a lot of clarity and details. Let us study them and understand the two concepts clearly.

Comparative Table

The comparative table below shows the differences in a tabular format and points them out on the basis of their meaning, usefulness from the business point of view, what it shows about the financial condition of business, the duration of each, the risk and reward, the type of return expected, etc.

Base of DifferenceDebt Equity 
MeaningFunds 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.
DurationDebt finance is comparatively short term finance.Equity, on the other hand, is long term financeLong Term FinanceLong term financing means financing by loan or borrowing for a term of more than one year by way of issuing equity shares, by the form of debt financing, by long term loans, leases or bonds, done for usually extensive projects financing and expansion of the company.read more for the company.
Status of the lenderDebt financier is a lender to the company.The shareholder of the company is the owner of the company.
RiskDebt falls under low-risk investments.Equity falls under high-risk investmentsHigh-risk InvestmentsA high-risk investment is an investment where the degree of risk is high, and there is a huge possibility that an investor may lose a substantial/all the amount invested. Such investments shall be made by investors who have a high-risk appetite since the chances of underperformance are higher than the usual.read more.
Types of financingDebt financing can be categorized by Term Loan, Debentures, Bonds, etc.Shares and Stocks can categorize equity.
Investment PayoffLenders 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 returnThe interest payableInterest PayableInterest Payable is the amount of expense that has been incurred but not yet paid. It is a liability that appears on the company's balance sheet.read more 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.
SecuritySecurity 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.

Which Is Better?

Whether debt financing is better than equity or vice versa, is a complex discussion, because the decision depends on many factors concerning the business, like type of business, size of operation, the existing capital structure, risk taking ability, market conditions, customer base, demand of the products and services, future plans for growth and expansion, etc. The management should study various debt financing vs equity financing examples to understand it better.

It is necessary to do a proper analysis of all the above topics and compare them with the basic characteristics of both the methods to decide the best option. Debt financing keeps the ownership with the management and also has the ability to reduce the tax burden, but it brings in the obligation to repay to lenders. Whereas equity dilutes ownership but there is no repayment pressure. The company does not have to face any legal action of damage to creditworthiness in case of bankruptcy.

It is essential for the management to strictly identify the position of the company in the market and then take the best approach. Management should consult best financial advisors and experts who have quality experience and knowledge in this field for the above purpose.

Pros And Cons

It is important to understand the pros and cons of any financial concept before implementation so that proper and informed decision is taken regarding the same. It will also help in understanding the suitability of the methods as per company requirement.

#1 – Debt Financing

Advantages
  • 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.
Disadvantages
  • 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.

#2 – Equity Financing

Advantage
  • 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.
Disadvantages

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 flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more, 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.

Debt Vs Equity Financing Video

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Comments

  1. Moaz says

    Thank you very much for your explanation, sir. I have learnt a lot from your articles. I believe there is a slight error in the second last paragraph here. Shouldn’t the debt/equity ratio be 1/2 instead of 2/1?

    • Dheeraj Vaidya says

      Many thanks Moaz for pointing out the error. I corrected the same.
      Best,
      Dheeraj

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