In the long-term perspective, the business has two options when it comes to using capital for growth. As long-term finance, the business can either choose Debt Finance or Equity Finance. Or, a combination of both to invest in developing large business projects.
Specifically, Debt Finance means using loan capital, or borrowing money from others. Equity Finance means selling a part of the ownership in a limited company to investors.
Let’s take a look at advantages and disadvantages of both ways of financing the business organization either through Debt Finance or Equity Finance.
Long-Term Finance: Debt Finance
Debt Finance means temporary money lent to the business organization by banks, private individuals and other businesses. This money must be returned in the future and additional interest on the loan must be paid. Typical examples of Debt Finance include long-term bank loan, mortgage, debentures (bonds) and convertible bonds.
Advantages of Debt Finance
- No loss of control. Lenders have no decision-making power in the running of the company. Lenders have no voting rights at the Annual General Meetings (AGM) either.
- No loss of ownership. The ownership of the company is not changed as no shares are sold to outside investors. The ownership of the company is not ‘diluted’ by the issue of additional shares either.
- Reduces TAX. Interest charges count as Expenses on the Balance Sheet. They are paid out to lenders before Corporate TAX is deducted.
Disadvantages of Debt Finance
- Must pay interest. Interest is charged on the amount borrowed and this increases Fixed Costs of the business. Interest must be paid when demanded by the lender, even if the business makes a loss.
- Must be repaid on time. The amount borrowed must be repaid on time and in full when it is due.
- Increases gearing. Long-term bank loans increase Long-Term Liabilities on the Balance Sheet. Therefore, borrowing money will increase the relative proportion of debt to equity that a company uses to support its operations.
Long-Term Finance: Equity Finance
Equity Finance means permanent money provided to the business organization by private investors, investment funds, investment banks or other businesses who then become the owners of a limited company. Typical examples of Equity Finance include issue of shares, crowdfunding, Venture Capital (VC) and Business Angels.
Advantages of Equity Finance
- Does not need to be repaid. It is permanent capital without any ongoing costs. It never has to be repaid to investors.
- No need for collateral. While the collateral is required to secure a bank loan, no collateral is required when selling shares (which represent a small part of the business) to the outside investors.
- Dividends do not have to be paid out every year. The Board of Directors (BOD) will decide whether the business will pay out the dividend to investors, or whether it will keep all earnings as Retained Profit. Also, if the business makes a loss, it does not have to pay dividends to shareholders as there is not profit.
Disadvantages of Equity Finance
- Potential loss of control and ownership. The increase in shareholders ‘dilutes’ the ownership of the company because now more investors own the business.
- Profits must be shared with others. Dividends on shares have to be paid from Net Profit After Interest and TAX. The more shareholders, the less of the earnings the original owners will keep.
- Complicated legal and regulatory issues. Producing a prospectus to offer the shares for sale on the stock exchange is expensive, complicated and time consuming. Also, any public limited company must produce annual reports which are made available freely to the general public.
In summary, both Debt Finance and Equity Finance are classified as long-term sources of financing a business organization. These funds, together with Retained Profits, are used by the business as Capital Employed in the long-term future growth of the company.
I highly encourage you to explore similarities and Differences between Private Limited Companies and Public Limited Companies.
