Debt vs. Equity Tutorial: How to Advise Companies on Financing (2024)

FAQs

How should a company choose between debt and equity financing? ›

Purpose of funding: If you need funding for a specific project or purchase, debt financing may be a better option since you can repay the loan over time. Equity financing may be more suitable for long-term growth plans.

Companies usually have a choice as to whether to seek debt or equity financing. The choice often depends upon which source of funding is most easily accessible for the company, its cash flow, and how important maintaining control of the company is to its principal owners.

Debt financing means you're borrowing money from an outside source and promising to pay it back with interest by a set date in the future. Equity financing means someone is putting money or assets into the business in exchange for some percentage of ownership.

Since Debt is almost always cheaper than Equity, Debt is almost always the answer. Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders' expected returns are lower than those of equity investors (shareholders). The risk and potential returns of Debt are both lower.

Equity financing may be less risky than debt financing because you don't have a loan to repay or collateral at stake. Debt also requires regular repayments, which can hurt your company's cash flow and its ability to grow.

Debt financing involves borrowing funds that must be paid back over time, typically with interest—however, the lender has no control over your business operations. Equity financing, on the other hand, involves raising capital by selling shares of your company.

Generally, a good debt ratio is around 1 to 1.5. However, the ideal debt ratio will vary depending on the industry, as some industries use more debt financing than others. Capital-intensive industries like the financial and manufacturing industries often have higher ratios that can be greater than 2.

If you need so much capital that you're already worried about repaying the debt financing for it, equity financing may be a safer bet. However, when you provide equity in return for a large amount of capital, your investors will likely require a proportionately large share of your company.

What are three questions financial managers ask when considering long-term financing? What sources of long-term funding (capital) are available, and which will best fit our needs? How much long-term funding will be needed to meet the monthly payroll? What are the organization's long-term goals and objectives?

In general, a lower D/E ratio is preferred as it indicates less debt on a company's balance sheet.

Why would a company choose to use equity financing? ›

Less burden. With equity financing, there is no loan to repay. The business doesn't have to make a monthly loan payment which can be particularly important if the business doesn't initially generate a profit. This in turn, gives you the freedom to channel more money into your growing business.

What Is the Debt-to-Equity (D/E) Ratio? The debt-to-equity (D/E) ratio is used to evaluate a company's financial leverage and is calculated by dividing a company's total liabilities by its shareholder equity. The D/E ratio is an important metric in corporate finance.