The Difference Between Debt & Equity
We have recently been approached to comment on the costs, benefits and risks of taking on additional debt or equity.
Before going on to examine the specific questions we were asked, we need to quickly examine the difference between debt and equity. The differences can be summarised as:
- unlike equity, debt has to be repaid usually at a specific time and this has it’s own inherent repayment/refinancing risks;
- debt interest is usually tax deductible which lowers it’s net cost to the business and, as it has to be paid before dividends, it is considered more secure and it’s “cost” is usually much lower than the cost of equity.
It is generally cost effective for businesses to use borrowed funds rather than equity because it is cheaper but only up to the level where they are sure that they can repay (or refinance) it when required and where the riskiness of the business as measured by the fluctuations in profit levels (actually cash flows) will not cause the business to become insolvent even temporarily.
Specific questions asked were:
Why take on debt or equity to grow the business?
There are two answers to this. ??Firstly, debt is cheaper than equity and so, as long as the returns from the growth financed by the debt exceed the cost of the debt (interest), the returns on the existing equity will be higher from financing growth using debt??. Secondly, existing shareholders may either not wish to or not be able to inject additional funds even where the business has good growth opportunities
What do investors/banks need to know?
The answers to this are slightly different for equity and debt investors.
For a debt investor, they are interested in whether they will get their interest payments and their capital returned when they fall due.
In the case of larger businesses, they can usually borrow based principally on the cash flow of their business and by giving certain promises re financial ratios and financial priorities. ??In the case of smaller businesses, they are usually required to provide some sort of additional security such as the debtors (invoice financing), specific assets (leases) or property.
For equity investors, they are always interested in the prospects of the business which usually resolves around the industry and the management. They may be purely financial investors where the future profits are of most interest or, in smaller businesses, they be active participants and may require a board seat and revised corporate governance (audit, risk management etc). Equity investors are also interested in when they will get their money back and so liquidity events (sale of business, stock exchange listing etc) are also of critical importance to them.
What is the benefit of taking on debt or equity when you do not need it?
As discussed above, debt is cheaper than equity and so, if a business can be partially financed by debt, the rate of return on equity will generally be higher so there is a simple financial case for using debt where available (subject to the risks etc discussed above).
From a business management point of view, there is sometimes a case for locking in (psychologically) key employees, directors and/or business partners by issuing them with equity. Stakeholders in businesses, even those with relatively small shareholdings, have a different perspective than those who are simply remunerated with money.
Tags: Cost Effective Borrowing, Costs & Benefits, Costs and Benefits, Debt, Debt & Equity, Difference Between Debt and Equity, Dividends, Equity, Invoice Financing, Refinance, Risk Management, Tax Deductable
Are you thinking of attracting debt or equity into your business? Do you fully understand the implications of your choice? We have our opinion but we’d love to hear your thoughts. Would you like our help with any of the above? Please call on +61 2 9258 1972 or go to our Contact page.