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What is the difference between debt and equity financing?

If you have not decided about the best alternatives to finance your business, there are multiple options you can use according to your needs. If you are looking to use external sources for raising funds, you can either use debt or equity to fulfill your purpose. Businesses need to generate funds for multiple uses such as expansion or reinvestment to develop new features in their products. Firms use the option of both debt and equity to raise funds since both sources of funding have their pros and cons. 

Debt financing occurs when a firm takes a loan or issues bonds to raise capital although the percentage of debt varies from firm to firm. Although these deals can be complex since companies opt for long-term financing but in principle, it is the same as households who apply for bank loans. Firms report the interest payment for the debt as operating expense on their income statement, but the principal amount is not considered to be an expense. 

Equity financing occurs when a company issues new shares to attract investors to invest more in the company. The main difference is that there is no guarantee that the invested money will be returned nor there is any interest payment. Instead, companies are expected to give a return to the investors in either dividend or helping the company to achieve growth so that investors can earn profits if they sell their shares. Some of the differences between debt and equity financing are evaluated below.

  • Involvement

The overall involvement of lenders is almost negligible since there is no share of ownership by the company owners. In such cases, the lenders only receive the money they lend plus interest payments. This makes using debt for financing purposes a safer option for the owners of the firm since they will not be weakening their control over the firm. However, this is not the case when equity financing is concerned. Since it involves issuing new shares, the existing owners are diluting their ownership percentage hence it may involve the risk of a hostile takeover by a rival firm. The negative aspect of using equity is that it gives a signal to investors that a company is having cash flow problems.

  • Profit-Sharing

The advantage of using debt financing is that the company does not give any share of the profits that it earned to the lenders. As mentioned above, the role of the lender ends after it collects that the loan that it gives and has no part to play in the decision making of the firm hence does not have any part in the profits. Equity financing comes at a cost for the firm since it would have to give a return to the investors for investing in the company. Companies who are not expanding anymore regularly pay their shareholders dividends from the profits that the company earned. These costs can be beneficial for the firm if it attracts new investors to put more money in the firm if they see stockholders getting good return s on their investments.

  • Payment Time: 

Debt financing can have a major setback for firms that face cashflow problems. As the debate between debt vs equity financing continues this will go against those that advise debt financing. A company has to pay the lenders first from the revenues before it decides to use its revenues on other stuff. The firm must pay its lenders even though it earns a profit or not which can complicate matters for the firm if it struggles with cash flow issues. This is not an issue with equity financing since the firm has no obligation to give dividends even if it is the standard procedure followed within the world. Dividends are paid last from the revenue that the company earns which can cause uncertainty if the stockholders feel that the company will not earn profits. 

  • Voting Rights: 

When debt financing is involved, the lender has no voting rights regarding the managing decisions taken by the firm since they do not have ownership of the company. The right of voting is solely for the stock owners and the lenders have no role to play in the voting decision which can potentially affect the future of the firm. Equity financing involves the voting process since it involves generating funds through shareholders who are further willing to invest in the company. Hence the voting rights allow more people to exercise their right to vote at the annual meeting when the company shows its performance over the past year. Thus, it can give more power to shareholders to exercise their opinions as they can dismiss the board of governors if the company fails to perform.

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