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