Equity vs. Debt
ADVANTAGES & DISADVANTAGES OF DEBT COMPARED TO EQUITY
ADVANTAGES
Because the lender does not claim equity in the business, debt does not dilute the owner's ownership interest in the company.
A lender is entitled only to the repayment of the agreed-upon principal of the loan plus interest and has no direct claim on future profits of the business. If the company is successful, the owners reap a more significant portion of the rewards than they would if they had sold stock to investors to finance the growth.
Except in the case of variable rate loans, principal and interest obligations are known amounts that can be forecasted and planned for.
Interest on the debt can be deducted from the company's tax return, lowering the loan’s actual cost to the company.
Raising debt capital is less complicated because the company is not required to comply with state and federal securities laws and regulations.
The company is not required to send periodic mailings to large numbers of investors, hold regular meetings of shareholders, and seek the vote of shareholders before taking specific actions.
DISADVANTAGES
Unlike equity, the debt must at some point be repaid. Interest is a fixed cost that raises the company's break-even point. High-interest costs during difficult financial periods can increase the risk of insolvency. Companies that are too highly leveraged (with large amounts of debt compared to equity) often find it challenging to grow because of the high cost of servicing the debt.
Cash flow is required for principal and interest payments And must be budgeted. Most loans are not repayable in varying amounts over time based on the company’s business cycles.
Debt instruments often contain restrictions on the company's activities, preventing management from pursuing alternative financing options and non-core business opportunities.
The larger a company's debt-equity ratio, the more risky the company is considered by lenders and investors. Accordingly, a business is limited in the amount of debt it can carry.
The company is usually required to pledge the company’s assets to the lender as collateral.
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