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Equity Financing

Equity financing, simply put is raising capital through the sale of shares in an enterprise i.e. the sale of an ownership interest to raise funds for business purposes with the purchasers of the shares being referred as shareholders. In addition to voting rights, shareholders benefit from share ownership in the form of dividends and (hopefully) eventually selling the shares at a profit.

Debt financing on the other hand occurs when a firm raises money for working capital or capital expenditures by selling bonds, bills or notes to individuals and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise the principal and interest on the debt will be repaid, later.

Most companies use a combination of debt and equity financing, but the Accountant shares a perspective which can be considered as distinct advantages of equity financing over debt financing. Principal among them are the fact that equity financing carries no repayment obligation and that it provides extra working capital that can be used to grow a company’s business.

Why opt for equity financing?
• Interest is considered a fixed cost which has the potential to raise a company’s break-even point and as such high interest during difficult financial periods can increase the risk of insolvency. Too highly leveraged (that have large amounts of debt as compared to equity) entities for instance often find it difficult to grow because of the high cost of servicing the debt.
• Equity financing does not place any additional financial burden on the company as there are no required monthly payments associated with it, hence a company is likely to have more capital available to invest in growing the business.
• Periodic cash flow is required for both principal and interest payments and this may be difficult for companies with inadequate working capital or liquidity challenges.
• Debt instruments are likely to come with clauses which contains restrictions on the company’s activities, preventing management from pursuing alternative financing options and non-core business opportunities
• A lender is entitled only to repayment of the agreed upon principal of the loan plus interest, and has to a large extent no direct claim on future profits of the business. If the company is successful, the owners reap a larger portion of the rewards than they would if they had sold debt in the company to investors in order to finance the growth.
• The larger a company’s debt-to-equity ratio, the riskier the company is considered by lenders and investors. Accordingly, a business is limited as to the amount of debt it can carry.
• The company is usually required to pledge assets of the company to the lenders as collateral, and owners of the company are in some cases required to personally guarantee repayment of loan.
• Based on company performance or cash flow, dividends to shareholders could be postpone, however, same is not possible with debt instruments which requires payment as and when they fall due.