The eifference between debt and equity financing

Companies use debt and equity financing to leverage capital expenditures, project development and operational expansion. Without leveraging company's financial growth is limited to retained earnings. For this reason debt and equity financing are often times considered vital to business expansion. Both debt and equity financing have advantages and disadvantages associated with them. This article will illustrate both forms of financing then come to a reasoned conclusion as to when and why each form of financing can be valuable.

Debt sources of financing

Debt financing includes collateralized bonds, debentures, business loans from banks, and lines of credit. Generally debt financing comes with an interest rate somewhere between 3-8% depending on the type. For this reason debt financing can be less expensive than equity finance depending on the expectations of the equity financiers. Debt financing may not always generate enough capital to perform intended business projects and goals as this type of financing tends to be more conservative in its lending requirements.

Equity sources of financing

When using equity as a source of financing a company is seeking capital from investors through the issuance of shares. These shares can be common or preferred i.e. having voting rights or priority in the case of company liquidation. Equity financing can also take the form of employee stock options which replace direct pay in the form of a corporate benefit. In the case of common and preferred shares, equity financing can be variable based on stockholder expectations and type meaning the higher the expectations, the higher the cost of financing.

Advantages and disadvantages of debt and equity financing

In business, both debt and equity financing have their advantages. Debt financing from financial institutions is subject to formal approval from lenders and monitored by organizations that rank the quality and credibility of corporate bonds. For this reason, debt financing can not only be a source of cheaper leveraging, but also an indicator of how viable a projects and goals actually are in terms of how convinced lenders and analysts are about the quality of the debt.

On the other hand, in a competitive market place, venture capital and equity financing can mean the difference between innovation, market share and a competitive edge. Often, such ventures can have more risk and therefore demand more return on investment making the financing more expensive. Nevertheless, if a business can garner a return on capital greater than the cost of goods and services including equity costs, then those projects become profitable.

Depending on the type of business, competitive ventures requiring excessive equity financing may simply be unnecessary, impractical or not in accordance with the goals of the business owners. In other words, not all businesses are designed to rapidly expand and yield growing profits on an annual basis. Businesses that simply intend on yielding a steady profit on an annual basis may benefit more from debt financing because of its structured and cost effective nature.

In the case of Equity financing, businesses that lack credibility, start ups and rapidly expanding businesses however may make positive use out of equity financing not only because it may be the only source of capital around but because it can provide the leverage necessary to accomplish the corporate vision.

Summary

Financing is a form of leverage not uncommon to most businesses in one form or another. Smaller businesses tend to use less, fixed or no equity financing due to corporate goals, cost of financing and business size. Contrarily, large high-powered industry leaders and high growth firms may find it essential to raise capital through equity financing to accomplish annual forecasts, corporate goals and owner objectives. Each form of financing has its advantages and disadvantages as this article has illustrated, but in the end financial leveraging is something that may be required for business survival and profitability regardless of cost.