Debt vs Equity

Define Debt vs Equity in Simple Terms

All companies need money to pay for taxes, the purchase of assets, payroll, and much more. If they don't generate enough cash from their current operations, they may need to raise capital.

Companies have a choice of whether to raise capital by issuing debt or equity.

Debt for a company can take the form of a loan or bonds. Taking on debt tends to be risky since debt incurs both interest payments and a necessary repayment of the principal.

Usually, companies will only take on debt (or more accurately, they will only be granted debt from a lender) if the lender is confident in their ability to pay it back.

This is determined by looking at the company's credit quality, their income, and the value of assets that can be used as collateral.

What Does Debt vs Equity Mean in Finance?

The principal of the debt is not considered an expense, but interest payments are.

They are recorded as operating expenses on a company's income statement and reductions on the principal are recorded as a reduction in liabilities on the balance sheet.

Interest payments are tax deductible, which is another advantage.

Equity refers to capital raised from selling a portion of the ownership of a company to investors.

Equity is safer for a company since there is no obligation of repayment, but has the drawback of diluting the total pool of investor's equity.

Since the value of a share is determined by a company's book value divided by the number of shares, selling more shares reduces the value of each.

Furthermore, selling equity means permanently relinquishing a portion of control over a company.

The only way to regain this control is to buy out the investors, but that often requires buying back the shares for more than they were purchased for.

There is also the expectation that by buying shares, an investor will personally profit. If this expectation is not met, investors in the future may become critical of current management.

When to Raise Debt and When to Raise Equity

As companies grow, many finance their business through a combination of debt and equity, as well as cash if they have the income to do so.

However, debt or equity can be more or less beneficial depending on the circumstances.

A startup, for instance, will have very few assets that can be used as collateral, and their profit margins may be razor-thin if they are even positive. They also have no track record to establish their credit quality.

This makes them highly unappealing to banks, who would consider the company too high risk to grant them a loan.

However, investors that see potential in the startup may be willing to purchase equity to finance operations.