debt vs equity financing acc 400

Running head: DEBT VERSUS EQUITY FINANCING 1

Debt versus Equity Financing

Amanda Smith

ACC/400

May 6, 2013

Dr. Samantha T. Duhn

DEBT VERSUS EQUITY FINANCING 2

Debt versus Equity Financing

When starting a business the two most common ways to raise funds are debt financing

and equity financing. Debt financing involves undertaking a bank loan or private loan. Equity

financing involves issuing stock in the company to sell to investors. It is the business owner’s

decision to choose the best financing option for the company. Most companies would be

inoperable without some type of financing options.

Debt Financing

Debt financing is a way for a business to raise funds to generate working capital.

Working capital is used to pay for projects and day-to-day operational costs. Working capital

measures a company’s liquidity and includes cash, inventory, accounts receivable, and accounts

payable. There are two types of debt financing, which are long-term and short-term. Long-term

debts are associated with large assets such as equipment, buildings, machinery, and land. Long-

term debt financing is spread out over a time frame of more than one year. Short-term debts are

associated with the operations side of the business and include payroll, supplies, and inventory.

Short-term debt financing is paid over the course of a year. Debt instruments used in debt

financing are anticipated to be paid in full in a specific time frame. Investors earn a return in the

form of interest and at the end of a bond or note term will receive the full face value of the bond,

which will include accrued interest. Debt financing can benefit the bond issuer by raising capital

in a short period.

Some examples of debt financing products are long-term loans and line of credit loans.

A long-term loan generally has a one to five year payback period and are usually secured and

guaranteed by the lender. The rates and terms vary, depending on the age of the business and its

financial status. Because the loan is secured should the borrower default on the loan or fail to


meet the terms of the note, the lender may take possession of the asset held for collateral. A line

of credit is an arrangement between the lender and business that establishes a set amount the

business can draw on at any time as long as the maximum amount is not exceeded. Funds from

a line of credit can be drawn upon when needed; however, lines of credit are mostly only

available to businesses that have raised equity capital as leveraging funds. The amount and

terms of the line of credit is based on the businesses needs and in most cases must be paid within

a year.

Equity Financing

Equity financing is a method of obtaining funds by issuing common stock or preferred

stock to sell to investors. Equity financing is a strategic way to obtain capital by selling a partial

interest in the company to investors. There is not a direct obligation to repay funds with equity

financing as there is with debt financing. Equity investors can become partners in the business

and therefore have some degree of control in the running of the company. The business owner

sacrifices total control of the business. When investors disagree or have different ideas about the

strategic direction or operations, they could pose problems for the business owner. More

financial risk is involved for the investor when partaking in equity financing. Because creditors

are paid first in the event of a business failure, the only way to recover the investment is to sell

the stock at a higher value.

Some examples of equity financing are venture capitalists and initial public offerings.

Venture capitalists are a professional investment organization. An advantage when choosing this

option is that the company will bring in experienced owners that can offer knowledgeable

opinions on how to run the company. An initial public offering (IPO) is a public offering

whereby shares of the company’s stock are sold to the public on a securities exchange. When a


company undergoes this process, it transforms from a private company to a public company.

IPO’s are a risky way to start a business because of the high costs associated with the process

and requirement to disclose pertinent information that could prove helpful to competitors.

Alternative Capital Structure

Choosing a structure is dependent upon the business’s needs. Debt financing allows the

business to pay for assets, such as building and equipment while paying installments over a

period of time. Equity financing does not have to be repaid and because the business will save

on payments, the generated cash flow can be used to further grow the company. Some

disadvantages of debt financing are loan payments, and defaulting on the loan can cause harm to

the business if assets are repossessed by the bank. Disadvantages of equity financing are giving

up partial ownership in the business and the requirement to share earnings with investors. If the

business is successful enough, the distribution of profits to investors can exceed what would

have been repaid on a loan.

Conclusion

A business owner must conduct thorough research to determine whether debt or equity

financing will work best for the business. Some businesses even combine the two to meet the

needs of an expanding business. The right type of financing will vary depending upon the type

of business, cash flow, profits, and startup fees.


References

Ewing Marion Kauffman Foundation. (2008). Debt financing. Retrieved from

http://entrepreneurs.about.com/od/financing/a/equityfinancing.htm

What is debt financing. (2013). Retrieved from http://www.wisegeek.com/what-is-debt-

financing.htm

Debt financing. (2013). Retrieved from http://www.businessfinance.com/debt-

financing.htm#axzz2S4HbGOKH

Richards, D. (n.d.). Equity financing-is it right for your small business. Retrieved from

http://entrepreneurs.about.com/od/financing/a/equityfinancing.htm

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