Choosing the source of finance can be a really challenging task for organizations. This is primarily because of the fact that there are various different options for companies to pick and choose from, depending on the situation and circumstances.
However, the two main categories for external financing for companies include debt and equity financing.
Debt financing is referred to organizations raising finance through long-term debt, which needs to be repaid at a certain interval in time.
It is extended by banks, or other lending institutions at a certain finance cost, which is also referred to as the interest charge. Debt financing, therefore, involves organizations procuring finance from an external party, in order to finance the required expenses.
On the contrary, as far as equity financing is concerned, it involves raising finance by selling shares. This tends to be one of the most common choices for organizations when it comes to raising external finance for the company.
This is because of the relative ease with which equity shares can be issued to the general public in the case where they have authorized share capital available.
Advantages of Debt Financing
As far as debt financing is concerned, it has the following advantages:
- The amount raised via debt finance does not alter the ownership structure of the company. It does not lead to shareholder dilution, and therefore, this is something that is generally acceptable to the public.
- Debt financing provides the company with numerous tax benefits. It helps the company save up considerable costs of raising finance.
- Interest payments that are made are fixed. In the case of higher profits, the company is not entitled to share those profits with the current debt holders.
- Debt financing is cheaper if the company is not listed or does not have authorized share capital.
Disadvantages of Debt Financing
Regardless of the various different advantages of debt financing, there are a number of pitfalls that need to be accounted for:
- Debt finances incur a finance charge in the form of interest. Interest has to be paid on the raised amount, regardless of the volume of profits generated by the company.
- Debt financing can only be procured if the company has collaterals to offer to the bank or the lending institution. In the case where the company does not have collaterals to offer, they might be charged a higher interest rate, or their loan application might be rejected altogether.
- Finance that is raised via debt financing needs to be repaid back.
- In case of non-payment, it might impede the credit rating of the company.
Advantages of Equity Financing
In the same manner, equity financing also has a number of options for the company. They are as follows:
- Finance that is raised via equity financing does not need to be repaid back.
- Equity financing is a cheaper option if the company already has authorized share capital available.
- In the case of common equity, the company can adjust for dividend payments, depending on the volume of profit they generate.
- Equity Financing does not require collaterals.
Disadvantages of Equity Financing
Despite the fact that equity financing does have numerous different advantages, yet it can be seen that there are a couple of drawbacks too that must be taken into account. For example:
- The option of equity financing is only available to big and large companies. These companies should be listed on the Stock Exchange in order to sell shares to the general public.
- Listing the company on the stock exchange is an extremely time-consuming and costly aspect. Therefore, being listed on the stock exchange is not always available to small and medium enterprises.
- Selling shares to the general public results in shareholding dilution. This means that the company will have to include shareholders in the general functioning as well as decision-making of the business.
Therefore, it can be seen that both debts, as well as equity financing, have their own perks and benefits. Choosing the best possible financing option is contingent on a multitude of factors, including the scope of the business, their current standing, as well as their aspirations for the near future.
Comparison of cost of equity vs cost of debt, as well as the weighted average cost of capital, tends to be a major factor in determining the optimal capital structure for the companies.
Between both the options, the main fact that should be considered by companies is the costs associated with both the financing options, as well as the choice of payback that the company prioritizes.
