What is debt and equity financing?

Differences Between Debt and 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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• Differences Between Debt and Equity Financing
• What is Debt Financing?
• What is Equity Financing?
• Debt vs. Equity Financing Infographics
• Key Differences
• Comparative Table
• Example to Analyze Debt vs. Equity Financing
• Advantages & Disadvantages
• Debt vs. Equity Financing Video
• Recommended Articles
• What is debt financing and equity financing with examples?
• What is the difference between debt and equity in finance?
• Which is better equity or debt financing?
• What is the meaning of equity financing?

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?

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 goodwillIn 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 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 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 dividendsDividends 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.

Debt vs. Equity Financing Infographics

Let’s see the top differences between debt vs. equity financing.

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Source: Debt Financing vs Equity Financing (wallstreetmojo.com)

Key Differences

• Debt financing is nothing but the borrowing of debts, whereas equity financing is about raising and enhancing share capitalShare capital refers to the funds raised by an organization by issuing the company's initial public offerings, common shares or preference stocks to the public. It appears as the owner's or shareholders' equity on the corporate balance sheet's liability side.read more by offering shares to the public.
• The sources of debt financing are bank loans, corporate bonds, mortgages, overdrafts, credit cards, factoring, trade creditThe term "trade credit" refers to credit provided by a supplier to a buyer of goods or services. This makes it is possible to buy goods or services from a supplier on credit rather than paying cash up front.read more, installment purchase, insurance lenders, asset-based companies, etc. In contrast, the equity financing sources 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. In contrast, equity holders will influence 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 interest rate needs to be provided on the same. In contrast, equity financing does not have any maturity date, and dividends must be provided when the company makes profits.

Comparative Table

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 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.

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.

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.

Comparing Exxon with its peers, 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.

Advantages & Disadvantages

#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

• 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 percentageThe profit percentage formula calculates the financial benefits left with the entity after it has paid all the expenses. Profit percentage is of two types - markup expressed as a percentage of cost price or profit margin calculated using the selling price.read more with investors.
• It is important to take the consent or consult your investors before making 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 only to 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

Conclusion

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 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.

Recommended Articles

This article has been a guide to Debt vs. Equity Financing. Here we discuss the debt and equity financing mechanism and its key differences and examples. You may also have a look at the following articles –

• Asset FinancingAsset financing is defined as a loan taken out by an organization using balance sheet assets as collateral, such as land and buildings, vehicles, machinery, trade receivables, and short-term investments. The asset's value is divided into regular payment intervals of the asset's unpaid portion plus interest.read more
• Financing Acquisitions
• Cash Flow From Financing Activities
• Market Capitalization