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The Ultimate Business Decision: Debt or Equity?

The Ultimate Business Decision: Debt or Equity?

Debt and equity are the two ways an entrepreneur can fund her business. Debt means borrowing funds. Let’s say an apparel store has got an order of 10,000 dresses for which they require a lot of material. But they don’t have enough cash to buy it. In order to avoid losing out on that order, they can borrow a loan for buying the material. Once, they receive the money for that order they can repay the loan with interest.  Such a situation where a business is making more money than the borrowed loan + interest is called as leveraging.
Equity means raising funds from others by selling a stake of the company. It also includes any money put in the business by its owner along with any profits that were reinvested back. Let’s say an apparel store wants money to expand their business overseas. But they don’t want to borrow a loan. An alternative to this would be raising money by selling equity. Equity gives people a chance to buy a stake in a business that they’re interested in. 

How to fund your business?

Few common types of debt are loans and credit. The benefit of debt is that it allows a business to use a small amount of money and grow it into a much larger sum. This in financial terms means ‘leveraging’.

So next time someone says this company has more debt than equity then you can say: it is highly leveraged.  

Payments on debt are generally tax-deductible. But the downside of debt financing is paying regular interests regardless of whether the business is making any profit or not. For smaller or newer businesses, this can be dangerous.

In comparison to debt, the main benefit of equity financing is that there is no fixed amount to be repaid. Only if the company makes profits it has to be shared with the investors (aka shareholders who own a share in the company). 

An investor puts in money in a company in exchange of shares. Over time, when they feel like the company’s value has grown and so has their share value they sell their shares for a higher price.  Meanwhile, shareholders also assume the risk that the business may make a loss and so they might lose their investment.

Since this risk is involved the cost of equity is much higher than the cost of debt.

What does that mean?  The cost of debt for a company are the interest payments it has to make to its lenders and the cost of equity are the profits it has to share with its shareholders. Since there is a risk factor involved for investors in taking up equity they expect a higher return than debt from the company, meaning it would be cheaper for a company to borrow money than sharing ownership rights. 

You can use a mix of both to fund your business. Ideally, the amount of debt to equity ratio should be less than 1 since it indicates that the company has borrowed less money. But it’s common for large, well-established companies to have Debt-to-Equity ratios exceeding 1 because they rather borrow money and repay it instead of parting with ownership of their company.

The formula to calculate your businesses’ Debt/Equity ratios is-

Total Liabilities (Loans, credit basically borrowed money) / Shareholders’ Equity (Money contributed by owners and people who want a stake in the company)

In a nutshell

Basis of comparison

Debt

Equity

Meaning-

Funds owned by the company given to them from another company/individual.

Funds raised by the company by issuing shares is known as equity.

What type of funds are they?

Borrowed funds

Own funds

What does it reflect?

An obligation

Ownership stake

What’s the holder called?

Lender such as bank

Shareholder, owners, proprietors, investors

What are the few forms?

Credit cards, debentures, bonds, business loans

Shares or stock

What are returns called?

Interests payments

Dividends and profits

How often do you need to give the returns?

Monthly, quarterly or annually

Not regular and varies depending on profits made

Does it require collateral?

Borrowing a loan may sometime require collateral i.e. you need to pledge something against which you’ll receive the money. In the case of non-repayment of the loan, the lender gets ownership of the collateral.

Equity does not require you to keep any collateral

That was the basics of debt v/s equity, if you have any questions feel free to ask us and we will demystify it for you!

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Talkative, clumsy, punny, intuitive are just a few buzzes of this queen bee. An aspiring business journalist looking to find her throne in the corporate world.

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