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Debt Financing vs. Equity Financing
Financing a business is always a challenge for small business entrepreneurs. A business without cash flow can cripple within months of its establishment. Capital is the basic requirement of every business organization, to fulfill the long term and short term financial needs. Therefore, until the foundation of the business has not been entirely formed, capital is crucial for its sustenance.
There are two general options for financing:
1. Debt Financing
Debt financing is borrowing money from a third party, i.e. a financial institution, with the promise to return the principal with an agreed interest. Startup companies and smaller firms use debt to leverage their operations and maintain ownership of their business.
2. Equity Financing
Equity Financing means investing money or asset into the business in exchange for some percentage of ownership. In Equity Financing, companies sell a portion of their equity i.e. ownership to the general public or private investors to raise capital. Equity Financing is a method of generating additional capital without increasing the company’s debt or financial burden.
Source of Debt and Equity Financing
Difference between Debt & Equity
As per the above differentiation between Debt and Equity Financing, an entity can choose a source of funding as per their need. Both the sources of financing have their merits and demerits.
However, every company should ensure to maintain a balance between debt and equity funds. The ideal debt-equity ratio is 2:1 i.e. the equity should always be twice the debt, only then can it be assumed that the company can cover its financial obligations effectively.
Therefore, every business can strategize on how much they want to raise fund by issuing equity shares (Equity Financing) and how much capital from Secured or Unsecured Loans (Debt Financing).
- By Rutuja Gour