Difference Between Debt Financing and Equity Financing: Every company reaches a point where they have to raise funds for their growth needs or to survive, preferably the former. This need for capital is primarily raised through two financing options i.e. debt financing vs equity financing.
In this article, we take a look at what these two are and which one could be optimal. Keep Reading to find out!
What is Equity Financing?
Equity Financing refers to raising capital by selling off the promoters’ stake i.e. part of the ownership within the company in exchange for funds.
One of the biggest advantages of equity financing is that the company receives funds without the obligation to pay back the capital.
These investments could be raised from the public through the markets by opting for IPO’s. Or in other cases through venture capitalists, angel investors, private equity funds, etc.
In addition to the funds, the promoter could also benefit from the connections, experience, and connections these new investors bring with them. This is because they too have an interest and benefit if the business succeeds. In the case of IPO’s the company could enjoy the listing benefits.
However, there is a tradeoff. In exchange for the funds, the new shareholders are given a stake which means that they now have a say within the company and can vote on important matters.
This could affect the decisions taken by the management as they now also have to take into consideration the interests of the new shareholders.
The risks could also extend to the promoters even being replaced in the management if they do not retain significant ownership.
What is Debt Financing?
Debt financing refers to borrowing money for a period with the intention of repaying the amount with interest. One of the most common ways of debt financing is be securing loans from banks.
However, debt financing also includes the company raising funds by selling off bonds, debentures, etc. to lenders.
In the case of debt financing, the amount is to be paid back at a fixed date and at a fixed interest.
One of the biggest advantages of debt financing is that the company can receive funds without the promoters letting go of any ownership. This allows them to maintain control over their business.
The lender has no control over the business and no say in the decision-making process. Other advantages include tax benefits as loans at times also include write-offs and deductions.
The challenge however is that the loan has to be paid back. Even if the company goes bankrupt it is the lenders who are paid off first. This could be a herculean task if the company is not yet profitable or runs into a rough patch. The funds could turn around and affect the company’s ability to grow too.
Don’t believe it? Ask Anil Ambani. The ex-tycoon is still battling cases to get out of the debt spiral even after most of his companies had to shut down or be sold off due to too high debt.
Too much financial jargon? We can understand the two sources of capital through an example:
Take for example Ineedfund Ltd. is looking to raise capital worth Rs. 50 lakhs for their growth requirement. For equity financing, the promoters would have to let go of a 20% stake in the company in order to raise the funds.
On the other hand, the company has been offered a loan of Rs. 50 lakh from banks which has to be paid back in installments over 4 years at an interest rate of 5%.
Here the management or the promoters have two options. The first is to let go of some stake that could affect their decision-making in the future. But here they are under no obligation to pay back the amount. The promoters can be tension-free and not worry about increasing their expenses.
On the other hand, they also can take up the loan from the banks. Here the promoters can keep their stake and run the company as they feel is right without answering to new shareholders. On the other hand, they have to constantly make sure that they make the loan repayments along with interest on time.
The right decision here depends on a number of factors, including the financial stability of the company and its ability to meet its repayment obligations, which can be influenced by factors like revenue growth, cash flow, and debt factoring. Debt factoring, which involves selling accounts receivable to a third party at a discount to improve cash flow, can play a significant role in the company’s ability to manage its debt effectively.
Is Debt Cheaper Than Equity?
Debt is considered to be cheaper than equity as includes additional risk taken over by the new shareholders. In the case of the company going bankrupt, the company pays off its creditors while winding off first.
The shareholders are in a position where they may lose 100% of the capital they invested. Hence due to the increased risk is taken up by the shareholders, they often expect and demand higher returns. Their shares are also further subject to volatility in the markets.
Is Debt Cheap Then?
Although the cost of limited debt may be lower than equity, too much debt can cause serious trouble for the company. This is because debt comes with interest that has to be paid. Increased debt directly results in higher interest payments.
Any slowdown in the business or other factors could hamper the business’s ability to pay interest putting the company into the defaulters’ category. This increases the risk for the creditors and increased risk will once again result in debt becoming more expensive.
This is because taking up loans now will become more expensive as due to the higher risk a higher interest rate will be charged. In the case of bond and debenture holders, this situation will also result in them demanding higher returns.
These circumstances could further also increase the risk for the existing equity shareholders. If a company defaults the effects of this news will be carried onto the share price. This leads to the equity shareholders looking to get compensated for the added risk.
So Debt Financing vs Equity Financing – Which is the Better option Then?
To find the answer to this question one must look at the company’s Weighted Average Cost of Capital (WACC). The WACC calculated the cost of the capital and the calculation uses appropriate weights for each category of the capital.
It includes both debt and equity in its calculation. It is calculated as follows.
What one should look for here is to ensure that the WACC is always balanced. If the WACC is leaning more towards point A it shows that the company has opted for too much equity with little debt. The end result however is a high cost of capital.
If the WACC is leaning more towards point B it shows that the company has opted for too much debt with little equity. Once again the end result here as well is a high cost of capital.
As you can see in the graph the most optimal point is C. This point represents that the company has managed a good balance between equity and debt. This shows the healthiest cost of capital for the company.
If the company is already leaning towards point A, it should try to balance its cost by financing its needs through debt. On the other hand, if the WACC of the company is already leaning towards point B it should try balancing it out using equity.
Is Balancing Debt and Equity an Absolute Rule?
Absolutely not. Raising funds depends on a number of factors. They may include the stage that a company is in. At times if the company is going through a rough patch it may be hard to even get investors interested.
The company will be forced to opt for the debt at higher rates. Or the company, unfortunately, may not even qualify for debt as it also requires collateral.
The willingness of the promoters to let go of their stake also plays an important role. The interest rates in the economy also keep fluctuating and accordingly make it favorable or unfavorable to acquire debt.
In addition, it is also important to note that raising funds through equity financing can also be an expensive affair. As floatation costs for IPO’s are expensive too.
Hence a company will also need sufficient funds to even raise funds through an IPO.
At the end of the day, it is up to the company to choose the most optimal source of funds. These could be debt financing vs equity financing depending on the situation.
It is also important for investors to be wary of too much debt financing or only equity financing. This can be looked into by observing the company’s debt-equity ratio. An optimal debt-equity ratio ranges from 1 to 1.5 but isn’t the only factor to look into while investing.
That’s all for this post. Let us know what you think of companies being extremely wary of debt in the recent past in the comments below. Happy Investing!
Aron, Bachelors in Commerce from Mangalore University, entered the world of Equity research to explore his interests in financial markets. Outside of work, you can catch him binging on a show, supporting RCB, and dreaming of visiting Kasol soon. He also believes that eating kid’s ice-cream is the best way to teach them taxes.
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