Debt Financing’s Benefits
Although excessive debt puts a company’s finances at danger, reasonable debt provides its own set of benefits.
- Debt financing helps the company’s promoters and owners to keep ownership and control.
- Owners are free to make decisions such as capital allocation, profit retention, dividend distribution, and so on without interference from lenders as long as they are paid on time.
- Debt financing is less expensive in the long run than equity, lowering the cost of capital.
- Debt obligations exist until the loan is repaid, at which point the lender loses all claim to the company.
Debt Financing’s Disadvantages
It must be paid on a regular basis, or it will be subject to harsh penalties and a lower credit rating.
Loans is only available to established businesses, and fledgling businesses that are experiencing cash flow problems in the early stages of their operations may find it difficult to obtain debt.
Debt financing also raises the company’s financial risk.
Equity Financing’s Benefits
- In contrast to debt financing, a company that uses equity financing has no commitment to repay money. Their risk and reward are linked to the performance of the company. If the company expands and makes a profit, equity owners receive a share of the earnings; but, if the company fails, equity owners lose the entire value of their stock.
- Due to a lack of assets, credit history, and other factors, equity funding is significantly easier to get than debt financing for young, recently founded, or unproven businesses.
- Equity financing attracts new investors, who frequently provide management direction and counsel to current business owners.
Equity Financing’s Disadvantages
- Diluting ownership stakes to generate capital results in a loss of control and decision-making power over the company.
- Too many stakeholders with opposing viewpoints can stymie decision-making and cause problems in day-to-day operations.
- When opposed to debt financing, equity financing is a more complicated and sometimes expensive process, such as in the case of an IPO (Initial Public Offering).
- As previously stated, equity financing is more expensive than debt financing, raising the cost of capital.
A company’s financial structure reveals its leverage and cost of capital. Some ratios that give an understanding about financial structure are asset to equity, debt to equity, and so on. Many organisations may diverge from their objective or optimal capital structure in the early years due to a lack of finances and so fail to consider the sources of funds.
In the long run, however, every company strives to achieve its target or ideal capital structure, in which the cost of capital is minimised and the firm’s value is maximised.