| July 21, 2023
Difference Between Debt and Equity Financing
Every business needs funds to start, run and prosper, isn’t it? For a business, usually there are two options to raise funds, one is debt and the other one is equity. In this article, we will talk about both debt financing and equity financing and see how they are different from each other. It is important for the investors to know how the company is funding its operations, and capital expenditures, as it plays a vital role in analysing the fundamentals of the company.
What is Debt Financing?
As the name suggests, Debt financing is a method of raising capital for your business by borrowing money. When a company borrows money, it has to repay the amount as well and that too along with interest. This is how any individual takes a loan from a bank and then repays the same along with the interest amount accrued on the loan. Companies, also avail loans from banks, private lenders, HNIs, and other sources.
However, the loan is not the only form of debt financing. There are other types of debt financing as well which will discuss in the later segment of the article.
The funds borrowed by the company can be used for running the business operations, paying off previous debts, or expanding the business or for any purpose, which benefits the business and the shareholders.
Debt financing can be secured and unsecured too. When the borrower borrows the fund from the lender by keeping some kind of collateral for security, then it is known as secured debt financing, while on the other hand, if there’s no collateral kept for availing the debt, then it is an unsecured debt financing process.
Types of Debt Financing
By debt financing, often people think it is only about loans, but there is a lot more to the list.
- Bank loans: This is the most fundamental way of debt financing and also reasonable for the company as compared to other debt financing options, traditional bank loans come at lower interest rates. This in turn helps the company in saving on the interest part.
- Corporate bonds: Another popular way of raising funds using Debt financing tactics is corporate bonds. These are debt instruments, which businesses use for raising funds from the public. However, the bondholders or people who are buying these bonds do not get any ownership right over the company or any other rights. This is one of the major differences between debt and equity financing methods. The investors who are buying the bonds are lending money to the company against which they will get a fixed interest, which is known as a coupon and the principal amount after a specified timeline. Therefore, both the company and the investors get benefits. The company get funds to finance its long-term goals, and expansion projects, while bondholders get fixed income against their investments.
- Non-convertible debentures: Indian companies to raise funds also use these debt instruments but these debt instruments are not convertible into equity shares. The investors get fixed interest on investing in these debt instruments as well.
- Convertible debentures: There is another way that corporates use to raise funds is convertible debentures. As the name suggests, these debentures can be converted into equity shares after a certain point in time. The interest rate on these debt instruments is comparatively lower as they offer the option to the investor to convert them into equity shares, get shareholding rights, and share the profits of the company.
- Small-business loans: Small-scale or MSMEs, which do not have the means of raising funds via bonds or debentures, often opt for business loans that are particularly meant for SMEs and MSMEs. These loans often come at a lower interest rate and longer tenure. However, there are multiple criteria, which businesses have to fulfil to avail of these loans.
- Line of credit: Another way of financing a business is using a line of credit. It is somewhat similar to an overdraft facility where the business is granted a lump sum amount of credit, but the interest is charged only on the amount, which is withdrawn or used by the business. Suppose, ABC company has been granted Rs. 10 crores of line of credit in 2022. It used Rs. 3 crores in FY 2022-23. So, for FY 2022-23, the interest will be charged only on Rs. 3 crores and not on the entire line of credit of Rs. 10 crores. This helps the business reduce their interest cost, and use the credit facility as and when required.
These are the most prominent debt financing options available in India, however, there are other options as well but they are not so commonly used by Indian businesses.
Pros and Cons of Debt Financing
So, now let’s see the benefits of using debt financing –
- Transparent Terms: When a company use debt financing, it has to give all the details of its business to the lenders, whether it is a bank, investors, or NBFCs. This makes the business transparent and helps the investors understand how the business is running, and its fundamentals.
- Raising funds without giving away ownership rights: The most important benefit of debt financing is that no lender gets any ownership right in the business/ company by lending the funds. Even when the general people purchase corporate bonds, they lend money to the company, not owning any shares. The business retains control over its operations and management when using debt financing.
- Tax benefits: The companies who uses debt financing, have to repay the amount borrowed along with interest. This interest is deductible from the profits of the company and thus benefits the company in tax savings.
Now you know why the company can opt for debt financing, but there are certain drawbacks as well that the companies need to consider.
- Early repayments: If the company avails loans from traditional banks or NBFCs, the timeline for repayment starts right after a month or a few of disbursing the loan. This makes it difficult for companies to plan long-term projects, expansion using traditional loans especially. However, this is not the case with bonds, or debentures, as the company requires paying the interest on these debt instruments regularly and repaying the principal after the instruments mature.
- Put the business at stake: If a business borrows from multiple sources, and fails to repay on time, this put the impression of the company at stake. It makes it difficult for the business to get further loans. It also affects the business as creditors and investors may shy away from investing or doing business if the debt-to-equity ratio is high.
So, now you know how debt financing works, or the options available for debt financing. Now let’s see equity finance's meaning and the options available to a business for equity financing and its pros and cons.
What is Equity Financing?
Equity financing is a method of raising funds by selling the equity of a company. This is where the company sells its ownership to others for capital. A company can sell its equity to private financers, investors, HNIs, and the public. When any company launches an IPO, it means, it is selling its equity to the public. Thus, shareholders are also known as owners of the company. Unlike, in debt financing, the company doesn’t need to repay the amount raised via equity financing as the company also sold a portion of its equity to the investor.
Types of Equity Financing
Equity financing involves different options such as –
- Angel investing: If you keep track of the economy and stock market, using equity stock watch nse bse, you can see multiple start-ups looking for angel investors. So, when a company is at its initial stage, raising capital is difficult for the general public for different reasons people do not know about the company, or the company has come up with some disruptive business idea which is futuristic but at present, it doesn’t hold ground and also for regulatory reasons. In this phase, angel investors are the best solution for companies looking for equity financing. Angel investors are high net-worth individuals (HNIs) or investment firms, private lenders who invest in the business idea and the company against a portion of the equity in the company. These angel investors analyse the business plan and see if there is a prospect for the business in the future. Usually, angel investors take equity shares or convertible debentures against their investments.
- Equity crowdfunding: This is quite picking up in India when it comes to equity financing. Crowdfunding is a method of equity financing where the company sells a small portion of its equity to a large number of people against a certain amount. However, there are different regulations on crowdfunding at present as well as it requires a lot of marketing and promotions.
- Venture capitalists: If a business is having high-risk but also high return potential, then venture capitalists take an interest in the business. They invest in the business in the initial stages of the business like angel investors. However, they take a higher portion of the equity in return for the capital they invest in the business since high-risk businesses often find it difficult to raise capital in the initial as well as later stages.
- IPO: When a company is well known, has a good client base and business is growing with a lot of prospects, and most importantly, can fulfil the SEBI criteria for launching an IPO and listing its shares on a stock exchange and going public, then the company can come up with an IPO for raising capital from the public in general. With an IPO, the company sells its equity shares to a wide number of people who applies for the IPO, and in return, the investors get a stake in the company and ownership and voting rights. Also read Tata Technologies Upcoming IPO.
Pros and Cons of Equity Financing
The benefits of equity financing include –
- No repayment of the funds: In equity financing, the company does not require to repay the funds it has raised. As it is selling its equity for getting those funds.
- No interest payments: Unlike in debt financing, the company does not require to pay any interest to the shareholders. If the company makes a profit, it may distribute a portion of the same in the form of dividends. The shareholders thus share the same risk and return ratio as the company, as they are also the owners. If the company makes a profit, and the share price increases, it’s a benefit for the investors, while in case of the company making losses, and the share price going down, the investors have to share the loss too as the value of their investment will go down.
- Going public: Only with equity financing, a company can go public that is via the IPO route.
Some shortcomings of equity financing which a company needs to identify are –
- Exceptional business prospects: Only around 10% of start-ups survive worldwide, and thus, being financed by an Angel Investor or Venture capitalist or getting crowdfunded is only possible if the business idea is disruptive, and have exceptional prospect.
- Regulatory requirements: For equity financing, there are different regulations, to which a company needs to adhere. This makes it difficult for companies to raise capital via equity financing when they need the capital the most.
How to choose between Debt and Equity Financing?
Choosing between debt and equity for financing a business is one of the vital decisions entrepreneurs need to take. However, it is never like only debt or only equity for financing a business. It can be a mix of both and that is how the businesses grow and prosper. However, one needs to know the ratio at which they need to mi debt and equity. As per financing experts, and business leaders, a good debt-to-equity ratio is two. This means the company derives 2/3rd of its funds from debt while 1/3rd from equity financing. Now, this ratio can vary but the maximum is two for most of the industries except a few like mining industries or manufacturing companies.
So, whether you are an investor or a company, knowing about debt and equity differences can help you with your investments and financing respectively.