Debt vs. Equity

Debt vs. Equity

When companies are looking to expand they have two routes to take when raising money, debt and equity. Debt refers to the borrowing of money, which must be repaid, plus interest. Equity refers to the raising of cash by selling interest in the company, such as stocks and bonds.

Debt involves the borrowing of money in the form of a loan. Debt can be advantageous, as a lender only has a claim on the repayment of the loan. Because of this, debt does not dilute an owner's ownership in the company. Debt is also a simpler process than raising equity, and doesn't require compliance with state and federal regulatory agencies.

Equity involves the selling of companies' interests, such as stocks and bonds, in order to raise capital. The main advantage of equity is that unlike loans, it doesn't have to be repaid. In addition, all liabilities and risks are shared with the company's investors. Since no loan payments must be paid, a company can use that cash to grow the business.

However, both debt and equity have their disadvantages. Debt requires repayment of the loan, and if a company is unable to make its payments, the company's assets are at risk of repossession. In addition, debt financing requires a company to borrow against future earnings, meaning the company has less cash to reinvest in the company, or pay dividends to owners and investors.

Equity financing requires giving up a portion of company ownership, and with that, a level of decision-making power over the business. If the business is successful, any earnings would be shared with the investor. Over time, the sharing of profits with investors could exceed the cost of repayment of principal and interest on a loan. In addition, the issuance of equity requires strict adherence to federal and state regulations and laws.

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