A:

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

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.

RELATED FAQS
  1. 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 >>
  2. On which financial statements does a company report its long-term debt?

    A company lists its long-term debt on its balance sheet under liabilities, usually under a subheading for long-term liabilities. Read Answer >>
  3. What are the differences between debt and equity markets?

    Understand the fundamental differences between the two primary investment markets of debt securities and equity investments. Read Answer >>
  4. What is the difference between cost of equity and cost of capital?

    Cost of equity is the percentage return demanded by a company's owners; the cost of capital includes the rate of return demanded ... 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. Small Business

    Is Equity Financing the Right Choice for Your Business?

    Discover the benefits and drawbacks of equity financing for a small business, and learn when equity financing should be used instead of debt financing.
  3. Investing

    Equity Multiplier

    The equity multiplier is a straightforward ratio used to measure a company’s financial leverage. The ratio is calculated by dividing total assets by total equity.
  4. Investing

    Verizon Stock: Capital Structure Analysis (VZ)

    Investigate Verizon's capital structure, and understand how debt and equity capitalization and enterprise value interact with each other.
  5. 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.
  6. Investing

    McDonald's Stock: Capital Structure Analysis (MCD)

    Learn about the importance of capital structure, and what equity and debt capitalization measures can tell us about the performance of McDonald's Corporation.
  7. Investing

    4 Leverage Ratios Used In Evaluating Energy Firms

    These four leverage ratios can help investors evaluate how energy manage their debt.
RELATED TERMS
  1. Long-Term Debt to Capitalization Ratio

    The long-term debt to capitalization ratio, calculated by dividing ...
  2. Leverage Ratio

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

    Debt service is the cash that is required for a particular time ...
  4. Net Debt

    Net debt is a metric that shows a company's overall debt situation ...
  5. Long-Term Debt To Total Assets Ratio

    The long-term debt to total assets ratio is a measurement representing ...
  6. Cost Of Equity

    The cost of equity is the rate of return required on an investment ...
Trading Center