Differences Between Debt and Equity Financing
The primary difference between Debt and Equity Financing is that debt financing is the process in which the capital is raised by the company by selling the debt instruments to the investors whereas equity financing is a process in which the capital is raised by the company by selling the shares of the company to the public.
Pepsi 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?
What is Debt Financing?
Debt means borrowing money, and debt financing mean borrowing money without giving away your ownership rights. Debts finance means having to pay both the interest and the principal at a certain date; however with strict conditions and agreements for the reason that if debt conditions are not met or are failed then there are severe consequences to face.
Usually, the rate of interest and the maturity or the payback date of debt borrowings is 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. Debt can be either a loan form or in the form of sale of bonds; however, they do not change the conditions of the borrowings 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 defiantly get your principal back along with the agreed interest above the same.
Debt financing can be both secure and unsecured financing security is usually a guarantee or an assurance that the loan will be paid off, this security can be of any type; whereas some lenders will lend you money on the basis of your idea or on the goodwill of your name or your brand. Various types of security can be offered to avail debt finance based on a security or debt finance can be availed as a different type of unsecured loans as well.
What is Equity Financing?
The company needs cash or additional cash to grow always. 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 stocks of the company to the financer.
The selling of stocks is giving ownership interest of the company to the financer. The proportion of ownership given to the financer depends on the amount invested in the company. Finance is required for every business and in every stage of business be it the startup or the growth of 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 in a loss. However, the loss of equity is the loss of ownership because equity gives you a say in the operations of the company and mostly in the difficult times of the company.
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, whereas 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.
- Debt financing is nothing but the borrowing of debts whereas equity financing is all about raising and enhancing share capital by offering shares to the public.
- The sources of debt financing are bank loans, corporate bonds, mortgages, overdrafts, credit cards, factoring, trade credit, installment purchase, insurance lenders, asset-based companies, etc whereas the sources of equity financing are angel investors, corporate investors, institutional investors, venture capital firms and retained earnings.
- Equity financing is less risky in comparison to debt financing. The lenders of debts will not gain the right to influence the management unless otherwise mentioned in the agreement whereas the equity holders will definitely have an influence on the management. The debts can be possibly converted into equity if the same is mentioned in the agreement whereas the conversion of equity into debts is next to impossible. The duration for which the debts are taken remains determined while the duration for which the equity financing has opted remains undetermined. Debts have a maturity date and a fixed rate of interest needs to be provided on the same whereas equity financing does not have any maturity date and dividends are required to be provided on the same and that too when the company makes profits.
|The 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 long term finance for the company.|
|What is the 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||Equity can be categorized by Shares and Stocks.|
|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.|
|What is the 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.|
|What is security?||Security is required in order to secure your money, however, a number of companies raise funds even without giving a security||No security is required in case of investing in a company as a shareholder as the shareholder gets ownership rights.|
Example to Analyze Debt vs Equity Financing
Analyzing Debt and Equity Financing of Oil & Gas Companies (Exxon, Royal Dutch, BP & Chevron)
Below is the Capitalization ratio (Debt to Total Capital) graph of Exxon, Royal Dutch, BP, and Chevron.
We note that Capitalization Ratio (Debt / Debt + Equity) has increased for most of the Oil & Gas companies. This means that the company has been raised more and more debt over the years. It is primarily due to a slowdown in commodity (oil) prices affecting their core business leading to reduced cash flows and straining their balance sheet.
Important points to note here are as follows –
- Exxon capitalization ratio increased from 6.5% to 18.0% in a 3 year period.
- BP’s capitalization ratio increased from 28.4% to 35.1% in a 3 year period.
- Chevron capitalization ratio increased from 8.1% to 20.1% in a 3 year period.
- Royal Dutch capitalization ratio increased from 17.8% to 26.4% in a 3 year period.
Comparing Exxon with its peers, we note that the Exxon capitalization ratio is the best. Exxon has remained resilient in this down cycle and continues to generate strong cash flows because of its high-quality reserves and management execution.
Advantages & Disadvantages
#1 – 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 telling 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 down.
- 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 in order to get a loan as security of repaying the loan.
#2 – Equity Financing
- The risk here is less because it is not a loan and it need not be paid back. Equity financing is a very 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 to 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 taking 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 to only take your cash benefits and let the investors run your business without you.
- Finding the right investors for your business takes time and effort.
Debt vs Equity Financing Video
When it comes to financing a company would 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 really 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 for a very simple reason and that is these companies have very limited assets to keep as a security with the lenders, they do not have a track record, they are not profitable and neither do they have cash flow and hence debt financing gets extremely risky. This 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 the debt and equity ratios of a company to make sure your company makes appropriate profits. Too much of debt can lead to bankruptcy whereas too much equity can weaken the existing shareholders and this can harm the returns.
Hence the key is striking a balance between the two in order to maintain the capital structure of the company. Well, the ideal debt/equity ratio is 1:2 where equity always needs to be twice the debt of the organization. Double the quantity of equity is an assurance that the company can easily cover all the losses born by the company efficiently.
Like we all know it is extremely important to keep and maintain the balance of everything, the same goes for business and investments. Maintaining an appropriate balance between financing your company can lead you to appropriate profit-making.
This has been a guide to Debt vs Equity Financing. Here we discuss the mechanism of debt and equity financing along with its key differences and examples. You may also have a look at the following articles –