Debt Financing

Debt is in the form of a loan to the organisation, either short term or long term, payable after an agreed period of borrowing. The debt carries a cost of borrowing, payable annually or as agreed over the period of borrowing. The lender (creditor) holds no stake or control over the proceedings of the business and does not have the right to participate in any meetings between shareholders and the directors. The interest payable to the lender is a tax allowable expense, but it must be paid regardless of profit or less arising in the period concerned.

The demerits of using debt as a source of finance are sometimes penalising. For instance, though the lender does not have any say in the operation, the payment of the interest on the loan holds priority over any dividends paid to shareholders. A legal action can be taken to force liquidation to collect the amount lent to the business, which must be repaid. Since the finance is normally guaranteed against an asset held by the business, a lender definitely has the upper hand in demanding a payback.

Debts usually have a low cost attached to them, especially long-term debts. As long-term creditors bear the lowest risk, their investments being secured against assets, they receive the lowest level of returns offered by the company. Therefore, a higher amount of capital is collected with a minimum return attributable to it; thus improving the cash flow of the company. In addition, the interest payment provides for a tax saving, as it is a tax allowable expenditure.

Equity Financing

Equity represents a shareholding in the company, on a short or long-term basis. This is not a form of borrowing but a permanent investment in the capital of the business. The shareholders may exercise their right to have their word in the operation of the business but not necessarily day-to-day. The shareholders in a partnership (partners), are themselves the managers of the business, but this may not be the case in private or public companies. The shareholders are normally separate from the management of companies (board of directors), who may themselves also own some shares.

The shareholder may not demand the investment back at any time, but may lose all or part of the investment in the event of insolvency of the company, therefore a higher risk is attached to each share held. The shareholder may not receive his/her share of profits (dividends) until the financial position depicts a sustained growth and expects a rise in future earnings. A shareholder bears limited liability in the affairs of the business and therefore, is not responsible for addressing any business liabilities.

Equity investments are not secured against the company assets and are prone to the highest risk level within the company. This suggests that the shareholders should receive a higher level of return to compensate for the risk being undertaken. Dividends are an appropriation of profit and are not tax allowable, compared to interest on debts. The dividends are distributable after interest and corporation tax has been deducted from operating profits. Then again, the company may feel that it should transfer some of the profits to a reserve for future contingencies. The remaining amount is then appropriated among the shareholders net of 10% tax deductible at source.

As we have seen, each of the major financing sources have their pros and cons but it is up to the company to find the best combination to address the funding requirement.