Debt vs Equity

Debt vs Equity

Financing is categorized into two fundamental types: debt financing and equity financing.

Debt vs Equity - Debt Financing

Debt financing means borrowing money that is to be repaid over a period of time, with interest. Debt financing can be either short term full repayment due in less than one year, INTERMEDIATE TERM 1 to 5 Years, or long-term repayment due over more than five years. The lender does not gain an ownership interest in your business and your obligations are limited to repaying the loan. In smaller businesses, personal guarantees are likely to be required on most debt instruments; commercial debt financing thereby becomes synonymous with personal debt financing.

Debt vs Equity - Equity Financing

Equity financing describes an exchange of money for a share of business ownership. This form of financing allows you to obtain funds without going into debt; in other words, without having to repay a specific amount of money at any particular time. The major disadvantage to equity financing is the dilution of your ownership interests and the possible loss of control that may accompany a sharing of ownership with additional investors.

Debt and equity financing provide different opportunities for raising funds, and a commercially acceptable ratio between debt and equity financing should be maintained. From the lender's perspective, the debt-to-equity ratio measures the amount of available assets available for repayment of a debt in the case of default. Excessive debt financing may impair your credit rating and your ability to raise more money in the future. If you have too much debt, your business may be considered overextended and risky and an unsafe investment. In addition, you may be unable to weather unanticipated business downturns, credit shortages, or an interest rate increase if your loan's interest rate floats.

Conversely, too much equity financing can indicate that you are not making the most productive use of your capital; the capital is not being used advantageously as leverage for obtaining cash. Too little equity may suggest the owners are not committed to their own business.

Debt vs Equity - Debt to Equity Ratio

Lenders will consider the debt-to-equity ratio in assessing whether the company is being operated in a conservative, creditworthy manner. We cannot give an example of a strong financial ratio, due to the fact each industry will have their own criteria. For startup businesses in particular, the owners need to guard against cash flow shortages that can force the business to take on excess debt, thereby impairing the business's ability to subsequently obtain needed capital for growth.

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