Debt vs. Equity -- Advantages and Disadvantages
In order to expand, it is necessary for business owners to tap financial resources. Business owners can utilize a variety of financing resources, initially broken into two categories, debt and equity. "Debt" involves borrowing money to be repaid, plus interest. "Equity" involves raising money by selling interests in the company. The following table discusses the advantages and disadvantages of debt financing as compared to equity financing.
- Because the lender does not have a claim to equity in the business, debt does not dilute the owner's ownership interest in the company.
- A lender is entitled only to repayment of the agreed-upon principal of the loan plus interest, and has 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 stock in the company to investors in order to finance the growth.
- Except in the case of variable rate loans, principal and interest obligations are known amounts which can be forecasted and planned for.
- Interest on the debt can be deducted on the company's tax return, lowering the actual cost of the loan to the company.
- Raising debt capital is less complicated because the company is not required to comply with state and federal securities laws and regulations.
- The company is not required to send periodic mailings to large numbers of investors, hold periodic meetings of shareholders, and seek the vote of shareholders before taking certain actions.
- Unlike equity, debt must at some point be repaid.
- Interest is a fixed cost which raises the company's break-even point. High interest costs during difficult financial periods can increase the risk of insolvency. Companies that are too highly leveraged (that have large amounts of debt as compared to equity) often find it difficult to grow because of the high cost of servicing the debt.
- Cash flow is required for both principal and interest payments and must be budgeted for. Most loans are not repayable in varying amounts over time based on the business cycles of the company.
- Debt instruments often contain restrictions on the company's activities, preventing management from pursuing alternative financing options and non-core business opportunities.
- The larger a company's debt-equity ratio, the more risky 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 lender as collateral, and owners of the company are in some cases required to personally guarantee repayment of the loan.