Key Takeaways
- Debt financing involves borrowing money, which must be repaid with interest.
- Equity financing raises capital by selling shares, providing ownership stakes to investors.
- Debt is often cheaper than equity if a company is expected to perform well.
- Interest from debt can be a tax advantage, reducing taxable income.
- Equity financing avoids interest costs but dilutes ownership and profits.
Debt Financing vs. Equity Financing: An Overview
Debt financing is when a business raises money for capital by selling debt instruments to investors. Equity financing is when a business raises money through selling shares in its business.
Debt financing comes with interest and obligations, while equity financing involves sharing ownership.
If a company is expected to perform well, then debt financing can usually be purchased for a lower effective cost.
It’s important to choose the right method for a company’s financial health.
Fast Fact
Understanding Debt Financing: Costs and Risks
When a firm raises money for capital by selling debt instruments to investors, it is known as debt financing. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid on a regular schedule.
Exploring Equity Financing: Ownership and Opportunities
Equity financing is the process of raising capital through the sale of shares in a company. With equity financing comes an ownership interest for shareholders. Equity financing may range from a few thousand dollars raised by an entrepreneur from a private investor to an initial public offering (IPO) on a stock exchange running into the billions.
Important
If a company fails to generate enough cash, the fixed-cost nature of debt can prove too burdensome. This basic idea represents the risk associated with debt financing.
Practical Example: Comparing Debt and Equity Financing
Provided a company is expected to perform well, you can usually obtain debt financing at a lower effective cost.
For example, if you run a small business and need $40,000 of financing, you can either take out a $40,000 bank loan at a 10% interest rate, or you can sell a 25% stake in your business to your neighbor for $40,000.
Suppose your business earns a $20,000 profit during the next year. If you took the bank loan, your interest expense (cost of debt financing) would be $4,000, leaving you with $16,000 in profit.
Conversely, had you used equity financing, you would have zero debt (and, as a result, no interest expense) but would keep only 75% of your profit (the other 25% being owned by your neighbor). Therefore, your personal profit would only be $15,000, or (75% x $20,000).
From this example, you can see how it is less expensive for you, as the original shareholder of your company, to issue debt as opposed to equity. Taxes make the situation even better if you have debt, since interest expense is deducted from earnings before income taxes are levied, thus acting as a tax shield (although we have ignored taxes in this example for the sake of simplicity).
Of course, the advantage of the fixed-interest nature of debt can also be a disadvantage. It presents a fixed expense, thus increasing a company’s risk. Going back to our example, suppose your company only earned $5,000 during the next year. With debt financing, you would still have the same $4,000 of interest to pay, so you would be left with only $1,000 of profit ($5,000 – $4,000). With equity, you again have no interest expense, but only keep 75% of your profits, thus leaving you with $3,750 of profits (75% × $5,000).
However, if a company fails to generate enough cash, the fixed-cost nature of debt can prove too burdensome. This basic idea represents the risk associated with debt financing.
The Bottom Line
The more uncertain a company’s future earnings, the higher the risk. Companies that are either in risky industries or small and just starting up are less likely to use debt financing than companies in stable industries with consistent cash flows. New businesses with high uncertainty are more likely to use equity financing because they may have a difficult time obtaining debt financing.
