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Debt VS Equity Financing

Updated: Dec 26, 2023


Equity Financing is a source of finance whereby company offers its equity shares i.e., proportionate ownership stake in the company in exchange of funds raised from either a particular set of investors (Private Placement) or general public (Initial or Further Public Offer).

For example, ABC Ltd wishes to raise funds through equity financing. Currently it has a share capital of Rs 10 Lakh (100000 shares of Rs 10 each). It further issues 20000 shares of Rs 10 each for raising 200000 Rs. Here, the company has raised 200000 Rs in exchange of 16.67% (200000/1200000 Rs) ownership stake in the company.


On the other hand, Debt Financing is a source of finance whereby company borrows funds from banks (bank loan or mortgages) or financial institutions or general public (by issuing bonds and debentures).


Factors to Consider while choosing Debt OR Equity Financing

There are several factors that need to be considered and analysed while choosing equity or debt financing which are discussed below:

1. Cost of Financing: Cost of financing is basically the cost that the business will incur for procurement of funds. Both debt and equity have their own cost. Debt financing has cost in the form of interest whereas equity financing has cost mainly in the form of dividend. However, in case of debt financing, tax benefit is available on interest paid. Along with that, equity financing is generally costlier than debt financing.

2. Debt Burden: Debt financing comes with a debt burden i.e.; the company has to make interest payment and principal repayment on a timely basis regardless of the fact that business is performing well or not OR there is profit earned or loss incurred by the business. However, there is no such burden or obligation in case of equity financing.

3. Existing Capital Structure: Existing capital structure is one of the most important factors to be considered as excess of both equity or debt can be disadvantageous for the company. Excess equity can increase overall cost of capital for the company whereas excess debt increases the probability of default by the company due to increased debt burden.

4. Dilution of Equity: Dilution of equity refers to reduction of ownership of existing shareholders due to issuance of new shares by the company. Existing investors may not agree with the idea of dilution of equity or they may not wish to share the controlling power of the company creating an obstacle for equity financing. However, there is no such dilution of equity in case of debt financing.

5. Stage of Business Cycle: It is vital to understand the stage of business cycle (Introduction/ Growth/ Maturity/ Decline) at which the company wishes to raise funds. If the company is at a stage where earnings are volatile, it may not be a good idea to raise funds through debt financing as it will increase the cash requirements of the company.


Ideal Debt-to-Equity Ratio

While analysing the existing capital structure, companies evaluate an important ratio known as Debt-to-Equity Ratio. Debt-to-equity ratio measures total debt against total shareholders' equity. Different industries have different ideal debt to equity ratios as per the business model, capital intensity and profit margins. For instance, highly capital-intensive industries such as airline industry or automobile industry have high debt-to-equity ratios whereas industries like tech industry and have low debt to equity ratio.


Debt-to-Equity Ratio of Top Listed Companies in Different Sectors

(as on March 31, 2023)


Tech Industry

Company

Infosys

TCS

HCL

Wipro

Debt to Equity Ratio

0.10

0.00

0.10

0.19

Automobile Industry

Company

Tata Motors

Mahindra & Mahindra

Hero Motocorp

Maruti Suzuki

Debt to Equity

2.77

0.11

0.01

0.02

Cement Industry

Company

Ultratech

Ambuja Cement

JK Cement

ACC

Debt to Equity

0.18

0.00

1.07

0.00

FMCG Industry

Company

ITC

Dabur

Nestle

HUL

Debt to Equity

0.00

0.11

1.07

0.00

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