In order to finance operations, a business has two main options, equity or debt. The mixture of equity and debt finance is referred to as the Capital Structure of the company.
As a matter of fact, it can be seen that capital structure is taken very seriously by companies because it has a huge impact on their profitability.
Hence, it is quite important to realize the fact that this decision is taken seriously by the company in order to extrapolate the best results that can guarantee a cost-effective capital structure that is beneficial to the stakeholders.
Furthermore, it must be noted that all companies have different capital structures. While some prefer equity financing, others are more inclined towards a debt structure.
Regardless of their preference or inclination, it is always preferable that companies opt for a debt-equity mix. However, in certain circumstances, it can be seen that companies normally choose equity financing over debt financing because of various reasons.
Reasons for Equity Financing as compared to Debt Financing
There can be a number of reasons why companies opt for equity financing as opposed to debt financing. This is primarily built on the premise that there are a couple of features within equity structures that act as an incentive for companies. These features are mentioned below:
- Firstly, finance that is generated through equity financing does not have to be paid pack. It is an investor’s investment in the company. The investor seeks a perpetual return from the equity in the firm.
- This acts as an incentive for the company since this amount does not have to be paid back. Hence, this can help companies to raise money, without having to worry about paying back the amount.
- In the same manner, equity does not come with a fixed financial charge. In the case of debt financing, companies need to agree to a fixed rate of return, in addition to the principal that is paid back to the company.
- Therefore, regardless of the performance of the company over the company, companies need to pay the finance charge to the debtors. In the case of equity, companies can choose to pay, or not to pay dividends in accordance with their performance over the past year. This acts as a very big advantage.
- When a company is raising finance from debt financing, they need to arrange for collaterals. However, in the case of equity financing, the company does not need to present any collateral. Hence, it is more convenient for a company to issue more shares (in the case where they already have authorized share capital available).
- Over the course of the amount, after the finance is raised, debt financing tends to take cash flows away from the business. On the other hand, equity financing does not take any cash away from the business. Hence, in this regard, it can be seen that for future cash flows, debt financing tends to adversely impact cash flows.
- Highly leveraged companies are not preferable from creditors’ perspective. This is predominantly because of the reason that companies with high debt tend to raise questions about the company since the real financial position of position after deducting for collaterals is quite dim.
- In the same manner, this tends to continuously create a negative pressure on cash flows, which remarkably reduces the valuation of the company.
- The option of debt financing might not always be available to companies because of their credit history. In the case where businesses do not have a good credit rating, banks and financial institutions might be reluctant to lend money to the company.
- However, with equity financing, this issue goes away because of the reason because it does not account for the past credit rating of the company. Hence, companies tend to rely on equity financing because of their poor credit rating.
The primitive reasons behind opting for equity financing as compared to debt financing can be seen as the relative edge equity financing has over debt financing. This is in terms of cost-effectiveness and long-term viability that is associated with equity financing.
However, it must not be ignored that companies might also rely on equity financing because of certain intrinsic factors of the company, like their credit history, or already existing high leverage within the company.
Regardless of the fact that companies might have to share profits, and existing ownership might get diluted, yet it is still worth considering the fact that the principal amount does not have to be repaid.