Introduction
The debt and equity financing are the basic choices of raising money for a company or growing business (Kokemuller, 2016). However, organizations usually have options for seeking debt or equity financing where the option most rely on the source of funding that can be accessed easily by the company, its flow of funds, and the importance of maintaining control of the firm to its principle owner. Therefore, the debt to equity ratio will indicate the figure of the company’s financing that is proportionately given by the debt and equity. This essay illustrates the strengths and weaknesses of debt and equity financing. Similarly, it also discusses the difference between debt and equity financing.
Strength of debt and equity financing
Debt financing allows business owners to pay for new buildings, equipment as well as other assets that are used to grow the company before the necessary funds are earned. This helps in pursuing aggressive strategic growth especially through the access of low interest rates. Debt financing is paid off in instalments over a given period. Similarly, business owners also benefit from the debt finances by not relinquishing any ownership or control of the company. A low debt-equity ratio is looked upon by creditors as favorable and will help the company when it needs to access additional loans at some point in the future.
Equity financing does not require repayment. That is the risks and liabilities of the company ownership are shared with new investors. Since there are no debt payments, one can apply the use of cash flow that is generated to further the growth of the organization and diversification into other areas. Moreover, maintaining a low debt to equity ratio put investors into a better place to obtain a loan when needed in future.
Weaknesses of Debt and Equity Financing
The main weakness of debt financing is that one need to repay the loan with interest, and failure to make loan repayment, the properties and assets of the company will be repossessed the lender, usually banks. Since debt financing is also borrowing against the future earnings, the use of all future proceeds to expand the business or pay the shareholders should be reallocated from the part of debt payments. Consequently, overuse of debt can severely limit the future growth of cash. Hence, hindering business growth.
The requirement for qualification. One need to have the adequate credit rating to get financing. Additionally, the business owners must have the financial discipline to make a timely repayment. That is they should exercise restraint and sound financial judgment when applying debt. Therefore, a company that depend entirely on debt could be viewed as a high risk by the potential investors. This could limit the access of equity financing at some point. By accepting to provide collateral to the lender, the assets of the business may be put at some potential risk. Moreover, you may be requested to guarantee the loan that may also put personal assets at risk.
Since it provides the investors with monthly payments, it will leave the company more vulnerable especially during tough economic times. To ensure that all investors are remunerated on a regular basis, an organization may forego any necessary expansion as well as liquidating valuable assets for future growth. In some scenarios, the business may be forced into bankruptcy. Hence required to liquidate its assets. Even though debts are repaid first, an enterprise may not be able to liquidate enough assets for full repayment of top priority investors.
Equity
When considering equity investment, the company may be given partial ownership, and it return, the enterprise provides the level of decision-making authority. Big equity investors always insist on the placement of the representatives on the executive positions in the organization. If the company takes off, the shareholders have to share the portion of the earnings with the equity investors. Over time, the distribution of the proceeds to other owners may exceed what have been repaid on a loan.
Raising equity financing is demanding, time-consuming and costly. Therefore, it may take the focus of the management away from the main activities of the business. The potential investors will look for a comprehensive informational background of the company. That is they will consider the previous financial results and forecasts as well as probing the management staff.
Depending on the investors, an organization may lose a certain amount of power while making management decisions. You will have to invest the time of management to give consistent information to be supervised by the investors. In the beginning, business owners may have smaller shares in the company both as a percentage and monetary terms. Therefore, the reduced share will be worth a lot more in the absolute monetary value especially when the investments lead the firm to become more successful. Lastly, there can be both legal and regulatory problems to comply with particularly when raising finance such as during the promotion of investments.
Contrast
Debt financingDebt financing is inclusive of long term loans that are obtained from the bank (Averkamp, 2016). It is when the company takes out a loan and issues bonds to acquire funds. However, there can be some complication regarding the details of large corporate debt deals. But the fundamentals are largely the same to the common household debts that are already familiar with people. Therefore, corporations can consider long term financing to buy facilities, equipment and other long run assets. For instance, a family may take out a mortgage loan to purchase a car or a house.
Debt financing sometimes has restrictions on the activities of the company. This may hinder the company from taking advantage of opportunities that exist outside the jurisdiction of its principal business.
Debt financing is the borrowing of funds without giving ownership bank (Averkamp, 2016). Therefore, it always comes with strict conditions plus payment of interest and principal at the specified period. Where failure to fulfil, the debt obligations will lead to severe consequences. For example, in the United States, interest on the debt is treated as a deductible expense during the computation of taxable income. This implies that the cost of active interest is not more than the stated interest when the company is profitable. Therefore, the addition of too much debt will increase the cost of borrowing money in the enterprise, and this will add some risks for the business.
Equity financing
Equity financing is the private investment of funds one may get in exchange for the ownership of shares in the enterprise. It often means the issuance of extra shares of common stock to the investors. With equity financing, a company may provide shares in the company’s ownership in return of capital. In this case, there is no promise of repaying the investment as in the loan repayment. Similarly, there is no component of interest when repaying the loan.
It has a cost of equity capital. Therefore, for the investors to agree to make investments in the firm, they expect to earn an acceptable yield that justifies the investment risk. However, the return varies over time, and across sectors as investors make a comparison of the potential hazards and the profile of risk rewards of investment opportunities. In case a company cannot meet the expectations of the returns, stockholders can share their ownership and shift the capital elsewhere to reduce the value of the firm and hamper future efforts of raising funds.
Equity investors own the company. Therefore, should the company prosper in future, they will have a significant side. The cost of capital for equity holders is a ceiling, and the higher upside is needed to reward investors for the increased equity financing risk that excludes the security. Lastly, the equity holders are paid lastly in the event of a bankruptcy situation.
The coffee giant, Starbucks Corporation have done debt financing to boost itself with additional debt financing. According to the regulatory filing, the corporation has made a request to borrow from the investors to add leverage to the present conservative structure of capital to be used for share repurchases. Starbucks succeeded by issuing as much as about $1 billion in debt minus affecting the materiality of its credit profile (Rudarakan, 2013). That is it still have a robust free flow of cash.
In conclusion, both debt and equity financing supply capital to the company. No investment is perfect in the sense that even the combination of debt and equity only lessens the limitations of each instead of making them disappear completely. Before backing a company, the investor should be aware of when and how he will be rewarded for the investments.
References
Averkamp, H. (2016). What is the difference between equity financing and debt financing? | Accounting Coach. AccountingCoach.com. Retrieved 22 August 2016, from http://www.accountingcoach.com/blog/equity-financing-debt-financing
Kokemuller, N. (2016). The Advantages and Disadvantages of Debt and Equity Financing. Smallbusiness.chron.com. Retrieved 22 August 2016, from http://smallbusiness.chron.com/advantages-disadvantages-debt-equity-financing-55504.html
Rudarakan, N. (2013). Starbucks Seeks More Debt Financing, In New Debt Issuance Worth $750 Million. International Business Times. Retrieved 22 August 2016, from http://www.ibtimes.com/starbucks-seeks-more-debt-financing-new-debt-issuance-worth-750-million-1402435
