Sources of finance in Business Studies

You’re in class, talking about sources of finance. The question comes up: “Which is better, debt or equity?” The answer?

“Well, it depends.”

Because, it does. 

Let’s start with some definitions. 

Debt is an external source of finance and involves borrowing money from banks and other lenders. The price of borrowing is the interest rate charged on the loan. A business has to repay the original loan, plus interest, over the life of the loan. The interest payments are an expense.

Equity is a source of finance that involves money that is invested into the business by its owners. In exchange, the owners receive a slice of ownership — a ‘share’ of the business. In return of equity, businesses need to reward their owners/investors, through the distribution of dividends. Equity finance is external to the business.

So, as a business, which should you choose? 

“It depends.”

Each source of finance has a cost. For debt, the loan must be repaid with interest. For equity, existing owners will have to give up some of their ownership shares to give to the new owners, which will also reduce existing owners’ share of business profits. 

With equity, existing owners must give up control. Their ownership of the business is diluted by the new owners. With debt, owners do not need to give up control — they do not have to offer a share of the business to lenders. But, with debt, owners have ongoing expenses in the form of interest repayments (and the principal, the original loan). 

A business needs to consider its circumstances, as well as the economic climate (including the level of interest rates), before deciding which source of finance it should pursue.

For example, if interest rates are relatively high, the size of repayments will also be relatively high. In this case, a business may prefer to seek equity which would be cheaper (in this context). Or maybe a business is focused on pursuing a particular strategy and does not want to lose control of decision making by bringing on new investors (equity finance); in this case, it may choose debt finance.

And think about this. If a business is performing poorly, and holds debt, it will still need to meet its ongoing repayments, even if revenue has decreased. If a business performs poorly, it won’t have the profits to be able to pay dividends, so investors won’t receive a return and the business doesn’t have the ‘cost’ of rewarding investors.

So, it all depends. You have to carefully consider the individual business.