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Debt Financing vs. Equity Financing: What’s the Difference?

Integrity Financial Groups, Inc. > Financial Education > Debt Financing vs. Equity Financing: What’s the Difference?

Debt Financing vs. Equity Financing Overview

When financing a company, the cost is the measurable expense of obtaining capital. Debt financing is the interest expense a company pays on its debt. Equity financing refers to the claim on earnings provided to shareholders for their ownership stake in the business.

  • When financing a company, cost is the measurable expense of obtaining capital.
  • With equity financing, the cost of capital refers to the claim on earnings provided to shareholders for their ownership stake in the business.
  • Debt financing can usually be obtained at a lower effective cost, provided that a company is expected to perform well.

Debt Financing

When a company raises money for capital by selling debt instruments to investors, it is known as debt financing. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid on a regular schedule.

Equity Financing

Equity financing is raising capital by selling shares in a company. With equity financing comes an ownership interest for shareholders. Equity financing may range from a few thousand dollars an entrepreneur raises from a private investor to an initial public offering (IPO) on a stock exchange running into the billions.

Provided a company is expected to perform well, you can usually obtain debt financing at a lower effective cost.

Debt Financing:

If your business needs $10,000,000 of financing, you can either take out a $10,000,000 loan at a 10 percent interest rate or sell a 25 percent stake in your business to your neighbor for $10,000,000.

Suppose your business earns a $5,000,000 profit during the following year. If you took the loan of $10,000,000 at 10 percent interest, your interest expense, or the cost of debt financing, would be $1,000,000, leaving you with $4,000,000 in profit.

Equity Financing:

Now, let’s say that you used equity financing. You would have zero debt and, as a result, no interest expense. However, you would keep only 75 percent of your profit ($3,750,000) and the other 25 percent ($1,250,000) your neighbor owns. The company profit would only be $3,750,000, or 75% x $5,000,000).

From this example, you can see how less expensive it is, as the original shareholder of your company, to issue debt as opposed to equity. Taxes make the situation even better if you have had debt since interest expense is deducted from earnings before income taxes are levied, acting as a tax shield. We have not gotten into taxes in this example for simplicity.

Debt financing can also be a disadvantage. It presents a fixed expense. This will increase a company’s risk. Suppose your company only earned $1,250,000 during the following year. With debt financing, you would still have the same $1,000,000 of interest to pay, leaving you with only $250,000 of profit, $1,250,000 – $1,000,000. With equity, you again have no interest expense but only keep 75 percent of your earnings, thus leaving you with $937,500 of profits (75% x $1,250,000).

Should You Use Debt Financing or Equity Financing?

In short, both. Although companies can make reasonable estimates, they are never sure what their earnings will amount to. The more uncertain their future earnings, the more risk is presented. As a result, companies in very stable industries with consistent cash flows generally use debt more than those in risky sectors or companies that are small and just beginning operations. New businesses with high uncertainty may have difficulty obtaining debt financing and often finance their operations primarily through equity. Integrity Financial Groups provides debt financing, equity financing, and debt/equity financing.

  • Debt Financing Will Not Dilute Your Equity
  • Debt/Equity Financing Offers Lower Rates and More Flexible Terms
  • Debt/Equity Financing Offers More Flexibility Than Traditional or Conventional Box Credit Lenders
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    About the author

    Dallin Hawkins brings over two decades of expertise within the finance sector, holding executive positions and distinguished as a top performer since 2003. Throughout his tenure, he has orchestrated and structured in excess of $60 billion in volume across diverse industries, including renewable energy, construction, transportation, manufacturing, mining, drilling, and oil and gas sectors. His adept negotiation skills and profound industry acumen have facilitated the successful management and funding of numerous intricate transactions. Leveraging foundational financing principles, Dallin consistently engineers structured and holistic funding solutions. His proficiency spans financial structuring, information technology, marketing, networking, and sales, underpinning his capacity to navigate multifaceted challenges with finesse. Moreover, Dallin's leadership extends beyond transactions, having personally mentored and overseen the development of countless sales executives. His guidance encompasses deal negotiation strategies, adept management of client expectations, and effective time management techniques tailored to the nuances of the finance domain. Notably, Dallin's recent financial venture stands poised to redefine and fortify the financial landscape through unparalleled growth trajectories.

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