Definition
Equity Finance is considered to be one of the most crucial and important sources of raising finance. When it comes to external sources of finance, a lot of companies opt for equity finance, because of the fact that it helps companies to generate a considerable amount of funds for expansion and to carry out day-to-day activities within the business.
Equity Finance can simply be termed as a source of finance, which involves companies selling a part of ownership of the company, against a monetary value.
This monetary value, also referred to as the share price is an indicator of the cost of ownership in the particular company.
The option of equity finance is mostly available to companies that are listed on the stock exchange, and that has already had an IPO (Initial Public Offering).
Furthermore, companies issuing new equity shares should also have sufficient Authorized Share Capital in order to issue new shares to the general public in return for shares in the market.
Benefits of Equity Finance
Equity Finance has a number of advantages for the company. In this regard, it is also imperative to consider the fact that equity finance can only be arranged if the company is legally compliant (and permitted) to issue their shares to the general public.
Upon being listed on the Stock Exchange, raising money via equity finance has the following advantages for the company.
- Cheaper Resource of External Financing: Raising money via equity financing is considered to be a relatively cheaper option, once the company is listed on the Stock Exchange. With Authorized Share Capital left to be utilized, all it is required to raise money via equity financing is to ensure that there are announcements and advertisements regarding the new shares being sold. This is a cheaper option as compared to other sources of finance.
- Changes in leverage: Leverage and gearing tend to be continuing issues for organizations. In this regard, a lot of companies do not want to impede their leverage by taking on more debt. Equity financing is the only way for a company to raise money, without adversely impacting the debt ratio.
- No need to repay the principal amount: This is perhaps the greatest advantage of raising money is equity financing. The amount that is raised in share capital does not have to be repaid. Against the investment, the shareholders are entitled to a dividend share at the end of every year.
- Dividends only have to be given out if the company makes profits: Unless the shares issued are preference shares, companies have an option to retain their profits for reinvestment in the subsequent year. Unlike debt (or other long-term financing options), equity financing does not incur a financial cost in terms of interest payments. This gives a much-needed flexibility for companies that are either going through a tough time or are looking to expand in the forthcoming years.
Disadvantages of Equity Finance
Regardless of the fact that equity finance is considered to be a highly favorable option when it comes to raising finance, there is no doubt to the fact that there are certain drawbacks and limitations pertaining to equity finance, that cannot be ignored. These disadvantages are enlisted below:
- Only larger companies have the option of raising money via equity finance: Given the fact that shares in a company can only be publicly traded at a stock exchange, it can be seen that this option is only available to those companies that are already enlisted on the stock exchange. Otherwise, small and medium-sized enterprises do not have the option to enlist themselves on the stock exchange.
- Expensive means of financing: Raising money through equity finance might prove to be expensive in the case where the company is not already listed on the stock exchange. In this case, the company will have to go through objectives like IPO, and underwriting. This is considered to be a time-consuming, as well as an expensive task.
- Dilution of ownership: Within equity financing, it can be seen that there are options to either issue common shares or preference shares. In the case where the company issues common shares, it can be seen that existing ownership is diluted, as common shares are supposed to get voting rights. Hence, existing shareholders might not be on board with this.
- Preference Share Dividends: If the company issues preference shares, then the company is required to pay them dividends, regardless of the volume of profit that the company has generated in a given year. This might take a strain on the company’s finances.
