Debt Versus Equity

Introduction

The choice between debt v equity financing is one of the most important decisions managers who need capital to finance their business will have to make.  In short, both offer a number of advantages and disadvantages and it is crucial to make sure you opt for the one that is best suited to your particular needs.

1.            Raising Finance Through Debt

Debt financing takes the form of loans which have to be repaid over a period of time – usually with interest on top as well.  The period of time over which businesses can borrow money can vary – some loans can be as short as six months, whereas other debt finance can span many years.  The main advantage of debt finance is that the interest charges levied by the lender can generally be deductible for tax purposes.  Conversely, debt financing can also have the disadvantage of leaving smaller businesses vulnerable if they have irregular cash flows or if interest rates suddenly increase.  It is possible to manage interest risk via a number of options such as caps or collars.

2.            Raising Finance Through Equity

Equity financing takes the form of finance obtained from investors in exchange for a stake in the business.  This sort of finance can come from a variety of investors, family members to specialist venture capital firms.  The distinct advantage which such finance has over debt is that the business is not obligated to repay the money.  Instead the investors will require a return on their investment from future profits.  However, a disadvantage to this type of finance is that the investors become part-owners of the business and therefore have a say in the running of the business.  As ownership interests become diluted, owner-managers will face a possible loss of autonomy or control.

3.            Considering the Gearing Effect

Raising funds via the debt route will have an effect on the company’s gearing.  Gearing is measured in percentage terms and is a fundamental ratio which investors will look at to assess the state of a company’s financial position.  Companies with high gearing are considered much more riskier than those with lower gearing.  In simple terms, gearing informs the investor how the company finances its operations.

4.            Dividends to Investors

As explained earlier in the tip sheet, when a company raises money through the equity route, the investors will expect a return on their investment (after all investors don’t generally put in their own money with the expectation of nothing in return).  One of the main methods of giving the investors a return on their investment is via a dividend, and company’s should be advised that dividends are not a tax deductible expense.

5.            Further Debt and Interest

When applying for finance through debt (e.g. a loan), the lender will often look at the ability of the company to make the interest payments.  This is a key ratio used by lenders and is measured in ‘times’.  It is worked out by taking the earnings before interest and tax (EBIT) and dividing this into the interest expense in the accounts.  For example, an interest cover such as 1.5 indicates that a company could pay interest 1.5 times out of the revenues it is generating which is generally higher risk than a company with a higher number.

6.            Issuing Preference Shares

Preference shares are essentially shares, but are very different from ordinary shares.  When a company issues preference shares to raise finance it needs to bear in mind that any dividends on preference shares must be paid BEFORE dividends on ordinary shares.  If the company is liquidated, then preference shareholders have a higher priority than ordinary shareholders, albeit a lower priority than debt holders.  Another issue to bear in mind is that in the case of cumulative preference shares, if the dividend is not paid, the unpaid amount is added to the next dividend due.

7.            Credit Rating

One of the main issues facing the decision whether to finance a business via the debt route or the equity route is what happens to the company’s credit rating.  One of the main drawbacks to financing a business via the debt route is that each loan is recorded on the company’s credit rating.  The more a company borrows, the higher the risk to the lender and the higher the interest payments are likely to be..

8.            Mezzanine Financing

Under this method of financing, no collateral is required.  The trade-off is a high interest rate.  A word of caution – the lender also has the right to convert the debt into equity (shares) in the company if the company defaults on the payments.  Despite the high interest rate, mezzanine financing appeals to entrepreneurs because if offers speedy liquidity, and even though there is the option to convert the debt into equity, most finance houses normally do not want to be equity holders.

9.            Hybrid Financing

It is fairly common for companies to use a combination of debt and equity financing to fund their venture.  When deciding on optimal capital structure, a common finance theory is the ‘Modigliani-Miller’ theorem which states that in a perfect world, without taxes, the value of a firm is the same whether it is financed completely by debt or equity, or a hybrid.  This, however, is considered too theoretical since real companies do have to pay taxes and there are also costs associated with liquidation and bankruptcy.

10.          Collateral

Even if a company plans to use the loan to invest in an important asset, it will need to make sure it can generate sufficient cash flows by the time loan repayments commence.  Lenders insist on a source of collateral in case the loan repayments enter into default.  In many cases, directors can also be asked for personal guarantees or be required to put a charge over their own homes, which is a very risky strategy and one which should not be entered into lightly.

Category: Debt