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¶ … Funds
One of the most important decisions that businesses have to make when sourcing for funds is whether to use equity or debt financing. Debt and equity financing happen to be the primary sources of capital for entities. In this text, I discuss these sources of financing in significant detail. In so doing, I will amongst other things highlight the main differences between them as well as the various business characteristics that make one source of financing better than the other.
Debt and Equity Financing: Key Differences
A business seeking capital has to choose from a wide range of funding sources. Such a business can either seek to borrow from banks, issue corporate bonds or get private loans from other investors with a higher risk appetite than banks. All these can be classified broadly as sources of debt financing. Commercial banks however remain the commonest debt financing sources (Kuratko and Hodgetts 2008, p. 211). On the other hand, the business can also decide to issue shares to the public through an IPO. Such a business may also approach venture capitalists or angel investors. These happen to be the main sources of equity capital. Debt capital according to Boone and Kurtz (2011, p. 576) "consists of funds obtained through borrowing." On the other hand, equity capital includes all those funds made available by the owners of an entity "when they reinvest earnings, make additional contributions, liquidate assets, issue stock to the general public, or raise capital from outside investors" (Boone and Kurtz 2011, p. 576). It therefore follows that by settling on debt financing, businesses...
On the other hand, a business that chooses equity financing provides to those providing funds with a piece of ownership in the said entity.
It is however important to note that one form of financing may in some instances be preferred to another based on some inherent business characteristics. For instance, while businesses that are relatively well established may prefer debt financing to equity financing, new companies/startups may find equity financing more appropriate. It is important to note that in comparison to startups; well-established businesses in most cases do have a demonstrated trading history as well as solid collateral in place. This makes it easier for them to access debt financing as they are deemed less risky by providers of credit. Such businesses hence prefer debt financing as it is relatively easy to access. However, startups on the other hand tend to have poor credit ratings and do not have a trading history. Further such enterprises may also in most cases lack solid collateral. In such a case, startups may prefer equity financing which may be easier to acquire in their early stages of development. Indeed, in the opinion of Weaver and Weston (2007, p.469), entities in their early stages of development may first have to build an equity financing foundation.
Debt financing may be considered most appropriate when both the potential return and risk of a given investment happens to be relatively high. As Longenecker et al. (2005, p. 239) point out, in terms of potential profitability, the utilization of more…
References
Boone, L.E. And Kurtz, D.L. 2011. Contemporary Business (14th ed.). Hoboken, NJ: John Wiley & Sons.
Kuratko, D.F. And Hodgetts, R.M. 2008. Entrepreneurship: Theory, Process, Practice (8th ed.). Mason, OH: Cengage Learning.
Longenecker, J.G., Moore, C.W., Palich, L.E. And Petty, W. 2005. Small Business Management: An Entrepreneurial Emphasis (13th ed.). Mason: Thomson.
Moles, P., Parrino, R. And Kidwell, D.S. 2011. Fundamentals of Corporate Finance. West Sussex: John Wiley & Sons.
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