A company that needs money for its business operations can raise capital through either issuing equity or taking on long-term debt. Whether it chooses debt or equity depends on the relative cost of capital, its 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 normally represents a shift in the composition of ownership interests. Debt financing is generally cheaper, but creates cash flow liabilities the company must manage properly. We explore both options below.
- Equity investments can come from a variety of sources and tend to produce more favorable accounting ratios that later investors and potential lenders will look upon favorably.
- However, lining up equity investors can take longer than arranging debt financing.
- Taking on long-term debt means a company is committing to direct repayments with specified interest amounts and maturity dates. Cash flow from operations must be able to cover this commitment.
Understanding Equity Financing
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. However, equity comes with a host of opportunity costs, particularly because businesses can expand more rapidly with debt financing.
Equity, for instance, can refer to additional financing with private money from existing owners—the founders put in more of their 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 public 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 via dividends. If the investment is large enough, equity investors might influence future business decisions.
Understanding Long-Term Debt Financing
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 the company 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.
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 owners a return on equity in perpetuity, where as long-term debt eventually matures.