Business houses, when in need of capital for business expansion, have two options to go for. They can either borrow money or sell shares of the company. The former is known as debt financing while the latter is known as equity financing. Let’s understand both of them in details:
What is Debt Financing?
Debt financing refers to borrowing money from banks, public and private enterprises in the form of loans or issuance of bonds. The company/or the government issues bonds with a fixed-interest rate and predetermined maturity period to raise capital either for business expansion or carrying out stalled business operations and other activities.
Debt financing is preferred when a company doesn’t want to dilute its ownership, or doesn’t want to go through the complicated process of releasing an Initial Public Offering. In this mode of financing, the lender is entitled to extra interest income in addition to the repayment of principal. S/he doesn’t have any share in the profits generated by the company.
What is Equity Financing?
In equity financing, the company sells a portion of its ownership in the form of shares to individuals and parties, who wish to hold a stake in the company. This is done through issuance of shares through an IPO.
The shareholders have a share in the profits generated by the company. This is known as dividend income. Apart from this, individuals profit from trading of shares on stock exchanges.
Debt v/s Equity
1. Involvement in the Business Operations of the Company
Since equity involves partial ownership of the firm, shareholders get voting rights and are actively involved in the key decision making for the firm. On the other hand, no voting rights are given to lenders.
2. Returns on Investment
If one invests in debt, s/he gets a fixed amount of interest at maturity, along with the principal invested. The returns are known beforehand. Whereas, when one invests in equity, the returns are not predetermined. If the company performs well, the share price of the company increases and so does the value of returns.
3. Dividend Income
There is no dividend income for debt holders of the company. They are only entitled to the interest and principal payment. However, equity investors get a share in the profits made by the company, in proportion to their investment in the firm.
It should be noted that the company is obligated to pay interest and principal to its lenders on time, irrespective of profit or loss. However, dividends declared by the company are purely dependent on profits made by the firm. In any financial year, it may choose not to distribute dividends.
The Investor’s Perspective
The availability of numerous financial instruments makes it difficult for investors to choose the best investment option for themselves. When it comes to investing in either equity or debt, below mentioned thumb rules can be followed to make a correct financial decision.
1. Investment Horizon
Returns from equities are quite volatile in the short run, owing to frequent market fluctuations, therefore, it is advised to investors to have a long term investment horizon for investment in equity. Also, even if one chooses not to trade the shares, it might take them a long period of time to appreciate substantially. On the other hand, returns from debt securities are quite stable, thus making it apt for investors with a short term investment horizon.
2. Risk Exposure
If you’re a conservative investor, investment in debt securities should be the preferred choice of investment, as the returns are fixed and predetermined. Although, if you have a moderate to high risk appetite, you can choose to invest in equities. The risk taken is highly compensated with the returns delivered.
3. Financial Knowledge
It is a well-known fact that investment in equity and debt requires vast knowledge of financial markets and enough time to track the market movement. If you are new to this, or don’t have time to track the market movement, you can opt for investment in mutual funds. These are open-ended schemes which pools in money from investors and invest them in equity and debt securities. Formulation of investment portfolio is done by professional experts who have a significant industrial experience.
To know more about Debt Mutual Funds, visit here: Debt Mutual Funds
4. Financial goals
Investors should be clear about their financial goals, and how a particular scheme is going to help in achieving those goals. If one is investing with the goal of long term wealth creation, equity investment should be preferred. Whereas, investment in debt is suitable for maintaining liquidity and fulfilling short term financial goals.