There are three primary ways companies finance their operations and growth in the short term and the long term: profits, debt financing, and equity financing. Profits are generated internally by the company, but debt and equity are external and are controlled by management decision making.
Both debt and equity financing supply a company with capital, but the similarities largely stop there. Let's break down the differences.
Debt financing
Debt financing is when a company takes out a loan or issues a bond to raise capital. While there can be much complexity in the details of large corporate debt deals, the fundamentals are largely similar to common household debts already familiar with individuals. Companies can accept long-term financing to purchase facilities, equipment, or other long-term assets, like a family takes out a mortgage loan to purchase a house or a loan to buy a car.
Companies can also use revolving credit, similar to a credit card or home equity line of credit, to pay for short-term capital needs like inventory, receivables financing, or general operating expenses like payroll.
Companies report the interest payments from their debt as an operating expense on the income statement. The principal portion of their debt payments is not considered an expense. The reduction of debt principal instead shows as a reduction in liabilities on the balance sheet.
Lenders have no claim to a company's profits outside of the original financing agreement. The upside for lenders is capped from the onset of the transaction at the interest rate, but their downside is also mitigated through loan covenants, collateral requirements, and a senior position to be repaid should the company face bankruptcy.
Equity financing
With equity financing, a company gives investors shares in the company's ownership in exchange for capital. There is no promise to repay the investment like in a loan arrangement, nor is there an interest component.
There is, however, a cost to equity capital. In order for investors to agree to invest in the company, they expect to earn an acceptable return that justifies the risk of the investment. That return varies over time and across industries as investors compare the potential upside, the potential risks, and the risk-reward profile of investment opportunities other than the given company. If the company fails to meet these return expectations, investors can share their ownership interest and move capital elsewhere, reducing the value of the company and hampering future efforts to raise capital.
Equity investors are owners of the company, which means they have significant upside should the company prosper in the future. The cost to their capital is a floor, not a ceiling. That higher upside is required to reward investors for the increased risk of equity financing, which excludes collateral and pays equity owners last in a bankruptcy situation.
When to use debt and when to raise equity
Generally speaking, most companies will choose to raise debt financing if it has the cash flow, the assets, and the ability to repay the debts. Companies that either do not qualify or pose too great of a risk for lenders are better suited to raise equity financing.
Start-ups are a great example. These companies don't have a track record, have limited assets for collateral, and may not yet be profitable or cash flow positive. That's too risky of a prospect for lenders. Investors, however, can accept these risks thanks to the prospect of a huge return should the company succeed.
Conversely, a company with an existing debt load may not be able to obtain any new debt financing. It's similar to being denied a mortgage loan -- the bank cannot accept the risk of weak cash flow, too much existing debt, or a poor credit history. In these cases, companies can seek out equity investors instead of lenders because equity investors will accept more risk if the potential future rewards are sufficiently high.
For investors, monitoring how a company chooses to manage its ratio of equity and debt levels is important, as too much or too little of either can be a bad thing. Too much debt can lead to bankruptcy. Too much equity can dilute existing shareholders and harm returns. The key is balance.
How much do you know about the ins and outs of investing? If you think you're ready to get started, or if you have questions, head on over to our Broker Center. We have lots of resources to get you on your way.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!
