As we all know, in a business, the two most common types of financing are debt and equity. What is the difference between the two? And which one can we say is a better option?
A company or a self owned business is said to take up debt financing, when it takes money from sources other than its own. It's a fairly straightforward procedure. Often the operations of the business demand cash which one does not necessarily have. And then the only way to go ahead with that business is to get some cash from outside sources.
So it may be an individual money lender, a bank, or several debenture holders. Business debt financing of course comes with a rider than you have to pay the whole thing off sooner or later, and pay an amount towards interest at a fixed or fluctuating rate.
The other option for you, in case you can't pay off the debt, is to give your creditor a share in the ownership of the business, or sell an asset to pay off the debt.
Debt financing is supposed to be a good idea for expensive short term projects. Suppose you get a pretty amazing project proposal and it needs to be completed in a certain amount of time, it is not always possible to raise all the money for it so fast
Debt capital can help you complete the project. You can then sell it, get a lot more money than what you took as debt, and pay off the loan and pocket the rest yourself. Your business capital remains untouched.
Needless to say, debt capital comes with an inherent risk. Interest rate which can be quite high. Usually you have to keep an asset as a security for the debt with your creditor. And in case your plan bombs, and you are not able to generate the revenue you had budgeted, you will not be able to pay off the debt and hence stand to lose the asset you pledged.
On the topic of the interest on debt capital, it gets total preference for payments over equity capital. And in case you haven't got the money to pay it, the interest payments will erode into your capital reserves and other reserve funds.
Equity financing is the money, owners of the business put in themselves. For the money the owners put in the business, they get a share of ownership and resulting business profits after interest payments and tax. The money stays in the business and the owners (shareholders) can get their money only on winding up or by selling their share to someone else.
The advantage is it is a low risk financing. From the point of view of the businessman, he has no one to pay back and to pay interest to, except himself. By not raising debt capital, a businessman can avoid eventuality of insolvency and having to pledge or sell assets to the lenders. A businessman can run a relatively low risk business with equity capital.
The flip side of equity financing is that the business will run quite slowly and won't progress as much as it could, had it taken debt financing. Suppose, like in the previous section, an expensive yet tantalizing business project comes to you, equity capital may often not be enough to see the proposal through.
And if you insist on preferring to overlook the option of debt financing, you stand to lose quite a few such projects.
In conclusion, it is quite difficult to run a business which is debt free, while taking debt for equity financing is a similarly bad idea. A healthy debt to equity ratio ought to be maintained if you are to run a business well. Because both have their pros and cons, which can be reconciled well by having a healthy balance of the two.