Finance managers world over are faced with the choice between debt financing and equity financing when looking for finance for their businesses. Both the types have certain merits and demerits. A little demystification will perhaps help towards the decision making process.
Debt financing the pro’s and cons
Debt financing is basically when you take loans from financial institutions, banks or government agencies which need to be repaid over a fixed time period. Debt financing has certain advantages and disadvantages, which are listed below.
The lending institution or bank has no say in the internal decision making of the business and has no ownership in the business. There is a tax advantage since the interest on the loan is tax deductible and you can usually plan and incorporate the repayment in your budget since both principal amount and interest rate are known.
Loan repayments may be used for working capital and cause cash inflow issues ultimately affecting growth.
- Flexibility with regard to repayment time is mostly non-existent.
- Too much of debt may cause your business to be identified as high risk entity and hence negatively affecting prospects of raising additional capital in the future.
- Your business may become vulnerable if your cash flow is affected owing to several reasons, such as drop in sales. This is especially true for new businesses
- You may have to provide assets of the business as security or collateral.
Equity financing is when an investor finances your business in exchange for ownership of shares or stakes in the business. The investing entity reclaims the investment from future profits. The advantages and disadvantages of equity financing are as follows:
- You don’t have to repay the money and hence it is less risky than a loan.
- You can access the investor’s network, adding more credibility to your business.
- Your working capital is not affected due to loan repayment compulsions and business growth gets a boost.
- In case the business fails, you don’t have to repay the investment.
- Loss of autonomy since the investor has certain control over the functioning of your business and also shares your profit.
- You will have to consult the investor while taking decision, which may result in disagreements and friction
- At times the returns taken by the investor may outstrip interest rates payable on loans.
- Finding an appropriate investor is both time and resource consuming.
The Final Call
Both forms are essential financing tools for a business and the decision as to which tool to make use of depends on the long-term business goals and the amount of autonomy or control that you wish to retain over your business. Ideally a business needs to use both the tools according to specific situation and needs. It is usually argued that new business may be in a better position if it goes for equity financing and then gradually also includes debt financing to its portfolio. As per experts, an ideal debt-to-equity ratio for a business should be between1:1 to 1:2.