The Key Difference Between Debt Financing and Equity Financing

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Feature Debt Financing Equity Financing
Definition Raising capital by borrowing funds that must be repaid with interest. Raising capital by selling ownership shares of the company to investors.
Ownership Dilution No dilution of ownership; lender is creditor, not owner. Ownership is diluted as new shares are issued to investors.
Repayment Obligation Obligatory repayment of principal and interest. No obligation to repay the capital invested by shareholders.
Cost Fixed cost in the form of interest payments. Cost varies; dividends are discretionary and dependent on profits.
Risk Higher financial risk due to fixed repayment obligations. Lower financial risk; dividends paid only if profits are available.
Impact on Cash Flow Reduces cash flow because of mandatory interest and principal payments. Does not affect cash flow directly unless dividends are paid.
Tax Treatment Interest payments are tax-deductible, reducing taxable income. Dividends are paid from after-tax profits and are not tax-deductible.
Control Lenders do not get voting rights or control over the company. Shareholders have voting rights and influence company decisions.
Balance Sheet Impact Recorded as a liability. Recorded as equity.
Credit Rating Impact Increases debt levels, which can affect credit ratings. Does not increase debt, can improve creditworthiness.
Flexibility Less flexible due to fixed payment schedules. More flexible as dividend payments can be adjusted or skipped.
Suitable For Companies with stable cash flow that can service debt. Startups or companies looking to raise large capital without repayment pressure.
Risk to Investors Lower risk as lenders have priority in bankruptcy claims. Higher risk as shareholders are last to be paid in liquidation.
Impact on Financial Ratios Increases leverage ratios like debt-to-equity. Improves leverage ratios by increasing equity base.
Long-Term Effects Debt must eventually be repaid, limiting future borrowing capacity. Equity remains permanently invested, providing long-term capital.
Examples Bank loans, bonds, debentures. Issuing common shares, preferred shares, venture capital.
Debt Financing vs Equity Financing
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