A company can arrange cash to finance its operations through either debt or equity. In debt financing,cash is borrowed from a lender at fixed rate for the specific period. However, in equity, cash is paid by investors to get a share in company’s earnings. The dividend is paid to shareholders after paying interest to lenders.
What is Debt Financing?
Debt financing involves borrowing money with fixed rate of interest (to be paid by a borrower to a lender) and the principle is paid back after a specific time period to a lender. Strict action is taken against a borrower if he/she fails to meet debt’s conditions and covenants.
What is Equity Financing?
Equity financing is a method to arrange money by selling shares or stocks to investors, in return for (ROI) return on investment. Being an owner of a company, investors receive dividend after interest payment to lenders.
Difference between Debt and Equity Financing
|Equity Financing||Debt Financing|
|What is it?||Money is acquired by selling shares or stocks to investors.||Money is borrowed by issuing bonds, notes or bills.|
|Ownership||Gives ownership to a holder.||Do not give ownership to a holder.|
|Preference||Being an owner, an investor is paid at the end. The dividend is not an obligation and can be avoided.||Preference is given to creditors from earnings before any other payments. Interest is an obligation which can not be avoided.|
|Cost||Cost of equity is higher because there is more risk for an investor than a lender.||It is cheaper because a lender faces less risk than an investor.|
|Advantages||Investors are prepared to provide follow-up funding to business for growth.||Interest is a tax deductible expense.|
|Disadvantages||Power to make decisions is lost as you issue more shares.||Debt’s conditions and covenants restrict company’s to take decisions within limits.|