A firm that needs money for long-term, general business operations can raise capital through either equity or long-term debt. Whether a firm uses debt or equity to raise capital depends on the relative costs of capital, the firm's current debt-to-equity ratio and its projected cash flow. Equity is a catch-all term for non-debt money invested in the company, and it normally represents a shift in the composition of ownership interests. Debt financing is generally cheaper, but it creates cash flow liabilities that the company must manage properly.

In general, equity is less risky than long-term debt. More equity tends to produce more favorable accounting ratios that other investors and potential lenders look upon favorably. Equity also comes with a host of opportunity costs, particularly because businesses can expand more rapidly with debt financing.

Even though it is common to throw around the terms "debt" and "equity" as if they separately referred to general homogeneous sources, there are actually many different subcategories.


Equity, for instance, can refer to additional financing with private money from existing owners – the founder puts in more of his personal funds. It can refer to contributions from angel investors or venture capitalists who spot an opportunity for increased future profits. Equity can even include a government grant or some other direct subsidy.

For publicly traded companies, equity is synonymous with the issuance of company shares. This may be the most fickle of all equity capital methods, because shareholders can be very skittish and suffer from a "once bitten, twice shy" mentality if they stop seeing returns.

The decision to use debt is heavily influenced by the structure of the capital transfer. Profits need to be shared with equity investors. If the investment was large enough, equity investors might influence future business decisions.

Long-Term Debt

Any payable due within one year or less is referred to as short-term debt (or a current liability). Debts with maturities longer than one year are long-term debts (non-current liabilities).

Company debt, by its nature, gives another party a claim against future business revenue. If a bank or bondholder gives a business $10,000 today, then the bank or bondholder expects that the firm will return future revenue equaling $10,000 plus accrued interest.

This creates another implicit obligation for the company: It must now generate enough future revenue to cover operating costs and pay back the $10,000 plus interest. More specifically, it must generate enough ongoing cash flow to cover ongoing interest expenses.

Perhaps the greatest advantage to long-term debt is that it allows for expansion without immediate revenue obligations. Startups or cash-strapped companies can use debt to strike while the iron is hot if current reserves are insufficient.

Long-Term Repayment

Equity and long-term debt both need to be repaid over time. Loans have very clear, direct repayments with specified interest amounts and maturity dates. Equity is repaid through ongoing profits and asset appreciation, which creates the opportunity for capital gains.

Even though the repayment on long-term debt is more structured and comes with a greater legal obligation than equity, equity is often more expensive over time. Successful companies have to continue to offer returns to equity owners in perpetuity; long-term debts eventually expire.

  1. How do equity financing and debt financing affect a company's financials?

    Learn about the differences between equity financing and debt financing and how they impact financials. Read Answer >>
  2. Is debt a relatively cheaper form of finance than equity?

    When financing a company, the cost of obtaining capital comes through debt or equity. Find out which method generally provides ... Read Answer >>
  3. What is the difference between cost of debt capital and cost of equity?

    Learn about how the costs of debt and equity capital differ and how to calculate each using interest and tax rates and stock ... Read Answer >>
  4. How do interest rates influence a corporation's capital structure?

    Learn about how changing interest rates can affect a corporation's capital structure because of their impact on the cost ... Read Answer >>
  5. How Is Equity and Shareholders' Equity Different?

    A company's equity typically refers to the ownership of a public company. Shareholders' equity is the difference between ... Read Answer >>
Related Articles
  1. Investing

    Evaluating a Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
  2. Investing

    Target Corp: WACC Analysis (TGT)

    Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
  3. Investing

    Will Corporate Debt Drag Your Stock Down?

    Corporate debt can mean a leg up for firms, or the boot for investors. How to tell the difference.
  4. Investing

    Understanding Leverage Ratios

    Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
  5. Small Business

    Why Equity Financing Is Worth It

    When a business takes on an equity partner, it is exposed to a number of advantages that debt financing simply cannot provide.
  6. Investing

    Microsoft Stock: Capital Structure Analysis (MSFT)

    Analyze Microsoft's capital structure to determine the roles of debt and equity in its financing, and explore what these trends say about the cost of capital.
  1. Capitalization Change

    Capitalization change refers to a modification of a company's ...
  2. Equity

    Equity is the value of an asset less the value of all liabilities ...
  3. Leverage Ratio

    A leverage ratio is any one of several financial measurements ...
  4. Debt Service

    Debt service is the cash that is required for a particular time ...
  5. Funding Operations

    Funding operations involve consolidating short-term unfunded ...
  6. Net Debt

    Net debt is a metric that shows a company's overall debt situation ...
Trading Center