Debt Versus Equity Financing Essay

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Debt vs. equity financing

As its name implies, debt financing involves borrowing money from a bank, individual, or company, with a promise to pay back the principle with interest. Any organization can make use of debt financing, spanning from a small single proprietorship to a large multinational. The owner of the business retains control over the organization and the only responsibility he or she has to the lender is to make the agreed-upon payments on time (McCormick 2012). These payments are also tax-deductible for the business, one of the attractions of debt financing (McCormick 2012). For this reason, it might be financially advantageous to use this form of financing, if interest rates are low enough. However, there are some drawbacks, namely the fact that when interest rates are high in relation to the business tax rate, the cost of borrowing may be prohibitive. Regardless of how well the business may do, the loan must be paid back to the creditors in a timely fashion. A failure to repay will impact the business' credit rating -- or in the case of a sole or joint proprietorship, in which the owner's assets are not separate from those of the business, the individual's credit rating.

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That is why it is so essential that the business knows it has some form of sustained revenue before taking a loan. "If you're investing in fixed costs, such as a new piece of equipment, then you likely won't see any cash returns from it in the near-term. If you need the money to invest in variable costs such as materials for the product you make or costs associated with each new client, than the debt investment should have associated cash inflow" (McCormick 2013). Debt financing is most suitable for companies that are already established; have sustained sources of income; and ideally the debt should be used to finance new equipment rather than to support the day-to-day maintenance expenses of the business. Businesses with steady sources of cash from customers, versus businesses with volatile or seasonal demand are also more suitable candidates for debt financing.

Equity financing involves selling shares or having an 'angel' investor or venture capitalist finance the company. Because equity financing is an investment, not a loan, there is no obligation to pay back….....

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