Debt Vs EquityIntroduction to Debt and EquityFundamentally, finance for businesses falls into two separate categories, debt and equity. Debt, quite simply, is a cash advance of money that will have to be paid back, normally with an interest figure on top. Business equity, on the other hand, is financing that comes from investors and does not necessarily have to be repaid, although investors will normally expect a degree of return for their investment.
The ratio of debt to equity is referred to as the ‘level of gearing’ to which the business is subject. Depending on the type of business and the level of risk that you wish to take, there will be different levels of acceptable debt that should be undertaken.
DebtMost new businesses will have to take on at least a certain level of debt, usually in the form of a bank loan. As a general rule, it is easier to obtain debt than it is to obtain cash input from potential investors. The terms of a bank loan may vary but almost all loans will require regular repayments of both interest and capital. The interest repayments are tax deductible which can be of great assistance to the cash flow of a new business.
Debt payments will have to be made first, before any dividends or payments can be made to equity investors. For example, if there are profits of £1,000 and loan repayments of £800, only £200 will remain available to be distributed to investors. Consequently, the level of debt finance in the business may have an impact on the appeal of your business to equity investors, in the future. It is also worth bearing in mind that if you default on a loan, the lender may petition to make you bankrupt, whereas an equity investor is unable to do so. The implications are that the risks associated with a debt are higher than with equity.
EquityEquity financing is generally seen as a very desirable way to finance a company. This is because it involves encouraging investors to put up cash in return for a stake in the business and for a share of the profits when the business begins to create a return. The major advantage of this type of financing is that if the business does not make any profit, you will not have to make any repayments. In addition, it is not possible for an investor to file for your bankruptcy if your business begins to fail, which makes it a much safer investment strategy.
There are, of course, disadvantages to equity financing, predominately surrounding the difficulty of actually obtaining investment. As investors do not receive a guaranteed return, they will require greater security that they are going to get a return on their initial input. This means that it will be necessary to have a very sound and convincing business plan in place. Many investors will also demand a certain level of input into the business and may even insist on sitting on the board of directors, which may result in a degree of loss of control over the running of the company.
Summary The ratio of debt to equity that a company has in order to finance their business is known as ‘gearing’;
debt is generally easier to obtain, but repayments will have to be made regularly;
failure to make the repayments can result in your lender filing for bankruptcy and may deter future equity investors;
equity investors are generally harder to locate, but do offer a less risky approach than debt and will only receive a return once the business becomes profitable;
however, equity investors may demand a say in how the business is run, meaning that a degree of control is lost.
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