An entrepreneur often creates debt when funding large purchases that could not be afforded under normal conditions. A debt arrangement means that the borrower loaned money to return the money through interest payments.
Equity is the worth of an asset minus the total of all liabilities on that asset. Equity financing is the course of increasing capital by the sale of shares in a business. The sale of ownership parts to improve the finances of a business is equity financing.
Equity financing has a broad spectrum to increase ownership shares. Friends and family members can be asked to invest funds and gain ownership shares accordingly. Financing from other private companies can also be considered in equity financing.
While this information may indicate that it makes the most sense to use equity financing instead of debt-inducing loans to finance aspects of your business, there are some advantages and disadvantages to both options. A comparison should be made between debt loans and equity financing to help you decide how to finance the needs of your business.
Debt vs. Equity Financing
Debt vs. Equity Financing is a strategic decision made by small and medium-sized business owners or financial officers. One should consider the pros and cons of increasing business capital through debt financing or equity financing. Here are the advantages and disadvantages of debt vs. equity financing.
Advantages of debt financing through equity financing
- When taking debt, the lender has no claim to equity in the business. Ownership remains the same. Business operation and bookkeeping decisions remain with the owners/entrepreneurs/executive management.
- When net profit is increased, the lender will only be given the debt money and interest.
If business progress and rewards are more significant, the entrepreneurs will reap the rewards. The lender will have no claim or share in the business rewards/profits. - Interests on debt can be subtracted from the business’s tax returns.
- There will be no need to seek the vote of shareholders in the business to make certain decisions.
Disadvantages of debt financing over equity financing
- Debt has to be paid back with interest, regardless of whether the business is running successfully or not.
- High interest on debt during the recession of business can dissolve the business.
- The bigger the debt-to-equity ratio in a business, the riskier business is considered by the investors.
- The company is usually required to place the company’s assets as a security/warranty to the lender.
Debt vs. Equity Financing: Which Way Should Your Business Go?
- How early are the finances needed? If there is no time to wait, then debt financing is left to invest in the business.
- How much finance is needed? If there is a small amount to be invested, then debt can be taken.
- If a company is running successfully and financing is required urgently, debt can be taken.
- If the business is growing and thriving, equity will provide a chance to attract investors with experience and knowledge. A good business relationship is established among the entrepreneurs/investors. It can have a remarkable positive impact on business in the long run.
- Debt is good only if you want to keep the business local and keep the whole ownership with you. But, if the company is progressive, reaching other markets other than your local community, you might need to go for equity financing.
Conclusion
Debt and Equity Financing are the two options available for small to medium-sized business owners when they need to invest more money but they lack the amount at the time of financing. Entrepreneurs must consider all options for choosing debt or equity financing. If the company faces a period of decline or recession, then the debt may not be a good choice.
Making financial decisions for your business can be a challenge. However, if you carefully weigh the advantages and disadvantages of debt vs. equity financing, you can do what is best for your company financially.
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