Business Finance: Debt vs Equity

• Business Finance focuses on the sources of funds for businesses.

Objectives

• To identify the different sources of short-term and long-term financing
• To differentiate debt financing from equity financing
• To understand the advantages and disadvantages of debt versus equity financing

Debt and Equity Financing

• The two major sources of financing are debt and equity.
• Another source of funds is the generation of funds from business operations.

Debt Financing

• Involves borrowing money from lenders without giving up ownership.
• It creates a contractual obligation for the borrower to pay interest and principal.
• Interest expense is tax deductible.
• It does not dilute the interest of controlling stockholders.
• Benefits are realized when debt is properly managed.
• Too much debt exposes the company to bankruptcy risk.

Equity Financing

• Equity financing is raising capital by selling company stock to investors.
• In exchange investors receive an ownership interest in the company.
• It involves the issuance of new shares of stocks.
• Retained earnings are considered internally generated funds, and equity.
• Equity financing is the safest form of financing.
• There is no mandatory dividend payment.
• Equity financing provides financial flexibility.
• Cash dividends are not tax-deductible.
• Issuing new shares dilutes the ownership of existing stockholders.
• Equity financing is the most expensive source of financing

Sources of Short-Term Financing

• Supplier's credit
• Advances from stockholders
• Credit cooperatives
• Bank loans
• Lending companies
• Informal lending sources

Sources of Long-Term Financing

• Equity investors
• Internally generated funds
• Banks
• Bond market
• Lending companies

Evaluating Operations

• Analysts should consider that operations bring in cash returns from year to year.
• Analysts consider investment proposals being made now and in the immediate future with expected cash returns.
• Evaluating operations applies to investments and borrowings, i.e. sources of funds.

Importance of Distinguishing Long-Term versus Short-Term

• Matching funds to the needs of the company or business is important
• Matching sources and uses of funds saves the business from defaults on obligations and incurring losses, while using funds at hand to earn profit.

5 C's of Credit

• Character: Willingness of the borrower to repay the loan.
• Capacity: Ability to generate cash flows.
• Collateral: Security pledged for loan repayment.
• Capital: Customer's financial resources.
• Condition: Current economic and business condition.