Difference Between Debt vs Equity Financing
The following article, Debt vs Equity financing, provides an outline for the topmost differences between Debt and Equity Financing. Every business requires capital to start its business, but more importantly, it might require some extra capital to expand its business or implement new ideas. Hence, there are two ways to fulfill the need for capital, taking a loan (debt financing) or equity financing (looking for an investor). Debt will attract interest expenses that need to be paid by the company, and with equity, the cost will be claimed on earnings to the extent of ownership of the shareholders. Some types of companies go for debt financing as per their business activities, requirement, and industry type, and some choose equity financing.
What is Debt Financing?
In simple words, debt financing means when a borrower borrows money from a lender, and in return, lenders charge interest on the debt, where an entity issues a debt instrument to the financer to raise money. (For example, Company ABC Ltd needs $200,000 of financing to extend the business; hence they issue bonds to take out a $200,000 bank loan at 10.75% per annum). There are various advantages of debt financing The lender won’t interfere in the business activity, Interest expenses will be charged under the income statement as it is tax-deductible. With any advantages, it also has some disadvantages as your business does not perform well and failing in its ideas, but debt is a liability, and the company is bound to pay debt and interest charges in any situation.
What is Equity Financing?
Equity financing is a convenient source of financing, where the company raises capital by issuing equity shares to the investors. The main benefit of equity financing is there is no such obligation to repay the amount to an investor or any kind of scheduled payments like interest in case of debt. When the company earns good profits, it grows, and it leads to an increase in the price of shares. This directly benefits the equity shareholders; equity shareholders also sell the share to other party and can convert it into cash. Any family and friends or any venture capitalist can invest in your business idea. Equity shareholders enjoy voting rights, which is very important to participate in the business activity; voting power will be to the extent of shares held by the shareholders. Equity financing is important in specific industries and businesses like tech startups. (For example, Company ABC Ltd needs $200,000 of financing to extend the business; hence they issue 20000 equity shares of $10 each to raise $200,000 to an investor Mr Y who wants to invest in the business.)
Head to Head Comparison Between Debt vs Equity Financing (Infographics)
Below are the top 8 differences between Debt and Equity financing:
Key Differences Between Debt vs Equity Financing
Let us discuss some of the major key differences between Debt and Equity financing:
- Debt means where you raise the capital from the lender by issuing some kind of debt instruments at a fixed rate of interest, whereas equity financing is a source where the company raises the capital by selling equity shares to the investors.
- Debt is a cheap source of financing as compared to equity financing. Debt expenses charge as expenses; hence it helps in tax savings. Whereas there is no such case in equity financing as it is a convenient source of financing.
- In case of the dissolution of the company, creditors will get their amount first, and equity shareholders will be the last to get the amount.
- Equity shareholders have ownership of the company to the extent of shares held. Creditors don’t have any kind of ownership of the entity.
- Creditors get interest expenses, which are fixed or pre-defined, whereas in the case of equity financing company pays a dividend to the investors as to when declared by the company.
- Equity shareholders have voting rights; hence they can cast their vote for business activity done by the company. In case of debt, voting rights are not available.
- In the case of debt, the company is under obligation to pay the interest expenses irrespective of profits or losses generated by the company. In the case of equity financing, shareholders receive the dividend (declared by the company).
Debt vs Equity Financing Comparison Table
Let’s discuss the top comparison between Debt vs Equity financing:
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| Basis of Comparison | Debt Financing | Equity Financing |
| Meaning | Debt financing means where the lender provides loans to the borrower and charge interest on the sanctioned amount. | Equity financing is a source of raising capital through selling shares. |
| Capital of Cost | Under this, Interest is charged on the amount, and the rate is fixed or pre-defined. | No scheduled fixed cost is involved in equity share. |
| Dividends Payment | There is no dividend that needs to be paid. | The company pays a dividend, as decided by the company. |
| Voting Rights | Lenders have no voting rights in the company, as they are the creditors of the company. | Equity shareholders enjoy voting rights as they have ownership. |
| Participation | Lenders have no participation in business activity, as there is no ownership. | Equity shareholder has involvement in the entity, as they have the ownership of the entity to the extent share held. |
| Settlement | Creditors need to be paid first. | They are the last who will receive the payment. |
| Profit-Sharing | The company doesn’t share profit with the creditors. | The company shares profit through dividends. |
| Repayment | Creditors need to be paid irrespective of generating profits or loss by the company. | The company needs to make a profit to pay off the shareholders, or shareholders can also sell the shares as well. |
Conclusion
As we have gone through both the types of financing and major differences between them, the entity can choose whichever source of financing they want as per their need; both the sources of financing have their merits and demerits. If they don’t want the obligation to pay regular interest expenses, they can pitch to investors to get invested in your idea. It also depends on the industry. But every company should ensure that just to take the benefits of leverage; it does not pay the high cost of capital. Every business can strategize how much capital they want to raise by issuing equity shares (Equity Financing) and how much capital from secured or unsecured loans (Debt Financing).
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