When it comes to corporate financing, there are two primary forms of capital: equity capital and debt capital. Each type of capital comes with benefits and drawbacks. And they have to be considered strategically by corporate managers to find an optimal capital structure.
Equity capital refers to money owned by the shareholders. It’s also known as “net assets” or “book value” as it is the residual interest in assets remaining after subtracting the firm’s liabilities.
This form of capital doesn’t carry repayment stipulation. It is because equity investors assume all the risks when investing in a business. And their incentive is high required rate of return, which makes equity capital can be extraordinarily expensive. One of the biggest drawbacks of equity financing is the perspective of losing total ownership of your business. The more investors you bring on, the more diluted your ownership gets.
This type of capital refers to money given to a business as a loan with the agreement that its principle must be paid by a predetermined date. In the meantime, the lenders who can be financial institutions, bondholders or even individuals receive interest payments in exchange for a business’s utilize of the capital. It is often known as the “cost of capital”.
The major advantage of using debt rather than equity is control and ownership. You can use external financial resources without giving up any controlling interests in your own business. This line of credit is also considered flexible where you can repay and borrow the right amount of money at any time and your liability is over once the debt is paid back. In the long term, using debt can be far cheaper than using equity.
But what does it take to use this form of capital? Budgeting for cash flow is required for both principal and interest payments. A cyclical business may face insolvency risk with fixed interest costs during difficult financial periods. And for many young businesses, debt capital can be unavailable due to low credit ratings and the lack of collateral assets.
Debt to Equity ratio
It is common for a company to use a fusion of equity and debt capital. Therefore, it is essential to measure a company’s debt relative to the value of its net assets. The idea of the Debt to Equity ratio is to gauge the extent to which a company is taking on debt to leverage its assets.
Debt to Equity Ratio = (Total Liabilities) / (Total Shareholders’ Equity)
A high debt/equity tells us that a company has been aggressive in growing with debt financing. High financial leverage comes along with both high potentials to generate more earnings and high insolvency risk. And it usually takes a lot of efforts to keep the balance while seeking for the optimal capital structure.