Decisions, decisions. Running a company must involve taking thousands of decisions a day as you can imagine. The decisions that have to be taken with respect to the capital are known as Financing Decision.
Taking financial decision is a critical process. Choosing the best source by minimizing the risk and maximizing the ROI is very crucial for a company. Business can utilize a variety of sources, majorly broken into two categories, debt and equity.
Usually, owners uses proportion of both equity & debt to finance the operations and achieve the goals. This relationship between debt & equity is technically known as Capital structure, also referred as “capitalization structure” or just “capitalization”.
Capital Structure = Debt + Equity
Equity is the owned fund while debt is borrowed. Let’s get an insight on these two sources.
Debt- Many of us are familiar with loans, whether you’ve borrowed money for a mortgage or for personal use. Debt financing a business is much the same. It involves borrowed money by one party (Debtor) from another (Creditor). It is an obligation for debtor to pay principle plus interest value to creditor at fix interval of time. The term “debt” tends to have negative implications. But even big corporate’s balance sheet include some level of debt. There are many sources of debt financing, the most popular source is Bank, but it could also be acquire from friends & family and even private corporate. Check out the best debt settlement companies.
Advantages/ Pros of debt financing
The primary advantage of borrowing money from lenders is control over the ownership. This is not the case with equity because shareholders have ownership rights. This allows the owners to take independent decisions as they have the ability to choose their own board members.
- Interest of debt is a charge against profit which means it is a deductible expense under income tax. This is beneficial for the company as it reduces the profit, hence the tax payable.
- Raising capital from debt source involves less cost as compared to the cost of equity. It does not include much documentation work and legal charges.
Disadvantages/ Cons of debt financing
- Debt are usually raised against collateral, which means lender has the right to claim on the borrower’s asset in the event of default in repayment.
- Borrowed capital obligates the owner to pay a fixed rate of interest which is usually high even after calculating the discounted interest rate at fixed interval of time.
Equity- Equity financing is the another source of raising money by selling company’s share or ownership to the interested investors. In exchange shareholder receives stake in equity and dividend on unfixed rate. It is measured by subtracting the value of liabilities from the value of assets of the company.
Equity = Assets – Liabilities
Venture capitalist is one of the most popular form of equity financing where the high net worth individuals/ firms supply the much-needed capital in exchange of ownership stake in the company.
Advantages of equity financing
- The biggest advantage of equity financing is that the founders remains unobligated to repay the money acquired through it. Equity investors get good returns in form of dividend and share value but without fixed payments or interest rate as in the case with debt financing.
- Equity does not take funds out of business. In fact, it reinvest the returns generated out of investment to increase the value of share (i.e. Earning per share or EPS). Higher the EPS of a company, the better is its profitability.
- Due to the autonomy of payment it let the owners to invest in long term plans.
Disadvantages of equity financing
- The primary fear of giving up equity is loss of control. When an investor subscribes a share, he gets voting power in the board. This can restrict the decision making capability of the owner.
- Equity involves more cost as compared to debt. It generally require more documentation, legal fee etc. An organization has to follow some laws before issuing equity.
Ultimately, the financing decision between debt and equity depends on the nature of business you have and whether the advantages outweigh the risks. Do some research on the norms in your industry and keep a track on competitors.
Many companies use a combination of both type of financing because the two sources are not independent but related to each other. It depends on the quantum of amount to calculate proportion of debt and equity.
Now that we know the difference between major sources of finance, we can understand the several types of debt and equity you may want to consider for your company.
Liked this content? Check out more:
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Series A Funding and How To Get It
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