Before getting into the difference between equity financing and debt financing, let us first understand what is the meaning of “financing”.
The term financing means a process in which an entity arranges funds for its business activities such as for making purchases, investing etc.. In other words, It’s a process of funding an entity’s business activities.
For instance, when you arrange funds to finance following business activities, it will be referred to as financing.
- To meet working capital expenditure.
- To buy plants & machinery and other assets for expansion.
- To acquire businesses and new markets
In general, we have two methods to raise fund for the company: equity financing and debt financing.
If you arrange funds from investors by issuing equity shares to them, then it’s referred to as equity financing. Instead, if the fund is arranged from a financial institution, such as banks, then it’s referred to as debt financing.
When you see a company come up with an initial public offering (IPO) to generate funds for its business, it’s nothing but equity financing. As per the current law, every company must disclose the main reason for IPO in its red herring prospectus. You can refer red herring prospectus to know exactly why the company has come up with IPO.
Here is a list of 5 biggest IPOs of all time.
A company can raise fund through equity in order to reduce its debt burden on the balance sheet.
Listed companies can also go for equity financing to get more funds for further expansion. They can go for the right issues or NFO.
One of the main advantages of equity financing is that the company has no obligation to repay the money back to shareholders. On the other hand if you have taken debt, then the company must pay back often with interest.
Here are the two major differences between equity financing and debt financing.
Ownership: Which is better equity or debt financing
In equity financing, company raises funds in exchange for shares. This means a certain percentage of ownership is sold to raise funds.
For instance, if you want to raise Rs 1,00,000 by selling 1,000 equity shares out of your total 10,000 equity shares, then you are losing 10% ownership of your business in exchange of Rs 1,00,000. In this way you are giving up some control.
Therefore, the disadvantage of equity financing is you lose ownership of the business based on the percentage of equity sold.
For example, if you are not owning more than 50% of the business, then you have a boss to whom you have to answer. You have to consult with your investors before making decisions.
In debt financing, you retain ownership and control over the business operation. The lender has no control over how you run your business.
Regular repayment
In debt financing, you need to repay the entire capital with interest based on the agreement you have with your lender.
Think of debt financing as a car loan or mortgages. High debt may create problems in an economic downturn. During a recession, it may be difficult for businesses to repay debt.
