The difference between equity financing and debt financing
/What is Equity Financing?
Equity financing involves the sale of a company’s stock to investors for cash. In return, investors may receive dividends, and will share in the outcome if the company is eventually sold.
What is Debt Financing?
Debt financing involves borrowing cash from a lender. In return, the lender expects to receive periodic interest payments, as well as the return of the debt at the end of the loan period.
Comparing Equity Financing and Debt Financing
There are several differences between equity financing and debt financing, which are as follows:
Repayment obligation. Equity financing does not need to be paid back, while debt must be paid back in accordance with a repayment schedule.
Ownership interest. The investors who buy equity have just acquired an ownership interest in the firm, whereas the lender does not own such an interest.
Repayment obligation. The company is not obligated to make periodic payments to investors, though they may eventually demand a dividend; conversely, the lender will charge interest for the use of its funds.
Impact on income. The receipt of cash in exchange for stock has no direct impact on the firm’s taxable income, whereas interest expense is deductible from taxable income.
Impact on liquidity. The acquisition of equity funding improves the liquidity position of a business (since it now has more cash), while taking on more debt funding makes its liquidity position worse - it now has an obligation to pay back the money.