Debt vs Equity Financing

Finance is the lifeblood of business organisations. Access to timely capital helps sustain and expand business operations. Among the various sources of finance, equity and debt financing are the most preferred and widely used.

As per estimates, in 2023, around Rs. 50,000 crores were raised through equity IPOs. On the other hand , a record Rs. 8.8 trillion worth of corporate bonds were issued. Let us understand both these prominent sources of finance in detail and see what can work best for your business.

Debt vs. equity financing - Which one to choose

Firstly, let us understand both these terms individually.

What are the pros and cons of debt vs. equity financing

Equity and debt financing have their benefits and downsides. Let us have a look at some major ones:

Pros of debt financing

• Control retention
  • Debt financing does not dilute ownership
  • Owners retain full ownership and control over decision-making
• Tax deductibility
  • Interest payments on debt are tax-deductible.
  • As per Sec 36(1)(iii) of the Income Tax Act, 1961, interest paid on loans borrowed for business purposes is allowed as a deduction
  • This reduces the overall tax liability of the business
• Predictable payments
  • Debt obligations come with:
    • Fixed interest rates and
    • Repayment schedules
  • This predictability makes it easier for businesses to forecast and manage cash flow

Cons of debt financing

• Interest payments
  • Debt comes with regular interest payments, which can strain cash flow
  • Its effect is particularly visible during periods of:
    • Economic downturns or
    • When the business is not generating sufficient revenue
• Risk of default
  • Failing to meet debt obligations leads to severe consequences, such as initiation of bankruptcy proceedings under Section 7 of the Insolvency and Bankruptcy Code (IBC), 2016
• Collateral requirement
  • Lenders often require collateral to secure the loan, which usually involves:
    • Pledging business assets or
    • Giving personal guarantees
  • This requirement paves the way for asset seizures, which can cause business losses and enhance risk

Pros of equity financing

• No obligation for repayment
  • Unlike debt, equity financing does not require:
    • Regular interest payments or
    • Repayment of the principal amount
  • Equity shareholders do not have any preferential right to the repayment of capital.
  • They share in the risks and rewards of the business.
• Access to expertise
  • Equity investors offer invaluable assistance to businesses by providing:
    • Management expertise
    • Business contacts
    • Access to alternative capital sources, and many more
  • This gives a competitive advantage to businesses and allows them to grow and succeed.

Cons of equity financing

• Ownership dilution
  • One of the major drawbacks of equity financing is the dilution of ownership.
  • By selling equity, businesses give away a portion of ownership and control in the business.
  • It has been observed that this leads to conflicts over decision-making.
• Profit sharing
  • Equity investors are entitled to a share of the profits.
  • This reduces the earnings available to the owners.

What is an optimal capital structure

Excess debt or equity can have severe business consequences. Thus, companies across the world prefer to create an optimal capital structure, having an ideal mix of debt vs. equity financing. This not only maximises a company's value but also reduces its overall cost of capital.

Let us understand in simple steps how businesses can find the right mix of equity financing vs. debt financing:

Step I: Know your costs

• Understand how much it costs to borrow money (debt) compared to getting funds from investors (equity).
• Look at interest rates for loans and the returns investors expect.

Step II: Watch your risks

• Consider how risky it is to:
  • Borrow too much or
  • Rely too heavily on investors
• Too much debt can lead to insolvency if you can't service the debt
• At the same time, over-reliance on investors can lead to:
  • Giving up too much control, or
  • Paying out too much in dividends

Step III: Perform business assessments

• Analyse your company’s:
  • Cashflows
  • Projected revenues, and
  • Pipeline projects
• This analysis will help determine your business’s potential to service regular debt payments and generate enough profits to sustain the operations.

Step IV: Try to achieve the balance

• Strive for a balanced mix of debt and equity financing that:
  • Minimises financial risk, and
  • Maximises growth opportunities
• As per the rule of thumb, a debt-to-equity ratio of below 2 is generally considered good.
• It indicates that for every two rupees of debt in the company, there exists one rupee of equity.

Conclusion

Equity or debt financing is a prominent source of business finance, offering distinct advantages and drawbacks. Debt financing provides control retention and tax deductibility, but comes with the risk of default, which can initiate insolvency proceedings under Section 7 of the Insolvency and Bankruptcy Code (IBC), 2016. On the other hand, equity financing offers no obligation for repayment but leads to ownership dilution and profit sharing.

To achieve an optimal capital structure, businesses must carefully balance their use of debt and equity financing. This can be done by laying an emphasis on understanding costs, managing risks, and assessing business performance.

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