When a business needs money to expand or cover expenses, it usually has two choices: debt or

equity financing. Debt financing means borrowing money from a lender, like a bank, and paying
it back over time with interest. Equity financing means raising money by selling part of the
business to investors. Both options help companies get the money they need, but they work in
very different ways. Business owners and managers need to understand the advantages and
disadvantages of each before making a decision.

One major benefit of debt financing is that it can lower a company’s taxes. That’s because the
interest paid on loans is tax-deductible. This means the company pays less in taxes overall,
making debt cheaper than it might seem at first (Ai, Frank, & Sanati, 2021). Another benefit is
that debt does not take away any ownership. When a business borrows money, the lender
doesn’t get any control or voting rights. As long as the loan is repaid, the business keeps full
ownership (Sitjà Fernández & Serrano, 2024).

Debt financing also gives companies a clear and predictable schedule for repayment. This helps
businesses plan ahead and manage their money better (Wardiman, 2024). Also, borrowing
money can send a good message to investors. It shows that management is confident in the
company’s future profits. Investors may view this as a positive sign, which can help the company
raise more money later on (Ai et al., 2021).

Still, there are some big risks with debt. One problem is that payments must be made on time,
no matter how well the company is doing. If sales drop or money gets tight, missing payments
can lead to serious trouble, including bankruptcy (Wardiman, 2024). Using too much debt also
increases financial risk. If the company doesn’t make enough money, it might not be able to
cover the loan payments. This can lead to stress and financial damage (Ai et al., 2021).

Debt agreements often come with rules. Lenders may ask for collateral, like company assets,
and include restrictions that limit how the business operates. These rules, called covenants, can
stop the company from borrowing more, paying dividends, or making large purchases without
approval (Sitjà Fernández & Serrano, 2024). Taking on too much debt can also hurt the
company’s credit rating, making it harder and more expensive to borrow money in the future
(Wardiman, 2024).

On the other hand, equity financing has some big advantages too. One of the best things about
equity is that the company doesn’t have to pay it back. If business is slow, there are no required
payments. This makes equity a safer choice during uncertain times (Sitjà Fernández & Serrano,
2024). Equity investors share in the company’s success, but they also take on some of the risk.
That helps the company survive when money is tight (Ai et al., 2021).
Equity financing also allows companies to keep more of their money. Without loan payments,
businesses can use their cash for new projects, hiring, or buying equipment. This is very helpful
for growing companies that need flexibility (Wardiman, 2024). Another plus is that equity
investors, like venture capitalists, can offer advice and bring useful business connections. This
kind of support can help companies grow even faster (Sitjà Fernández & Serrano, 2024).

But equity financing has its downsides too. The biggest one is losing part of the company. When
a company sells shares, it gives up some ownership. This means the original owners may have
less control over decisions (Ai et al., 2021). Equity can also be more expensive in the long run.
Investors usually want bigger returns than lenders because they’re taking on more risk. This
makes the cost of equity higher than the cost of debt in many cases (Ai et al., 2021).

Even though companies don’t have to pay dividends to equity investors, many still do. Over
time, shareholders may expect regular payments. This puts pressure on the company to share
profits instead of reinvesting them (Wardiman, 2024). Another risk is that selling new shares can
hurt the stock price. If investors think the company is overvalued or weak, they may sell their
shares, which can make future fundraising harder (Sitjà Fernández & Serrano, 2024).

Most companies don’t rely only on debt or only on equity. Instead, they use a mix of both. This
is called an optimal capital structure. It helps companies get the benefits of both methods while
reducing the risks. According to Ai et al. (2021), this approach is known as the “trade-off
theory.” Companies balance the tax savings from debt with the risk of financial trouble and try
to find the best mix for their needs.

For example, a new start-up might choose equity because it doesn’t have steady income and
can’t afford loan payments. Equity also brings helpful investors who can guide the business. But
a large, stable company might use more debt because it can handle the payments and wants to
keep control of its shares (Wardiman, 2024).

Business leaders should think about several things when deciding between debt and equity.
First, they should look at their cash flow. If the company makes money regularly, it can handle
debt. Second, they should think about how much control they want to keep. If owners don’t
want to give up control, they might prefer loans. Third, they should compare their debt levels
with other businesses in the same industry. Finally, if they do issue equity, it’s best to do it when
the stock price is strong to reduce ownership dilution (Sitjà Fernández & Serrano, 2024).

In conclusion, debt and equity are two useful ways to raise money, but each comes with trade-
offs. Debt helps businesses keep control and save on taxes, but it brings financial risk and fixed
payments. Equity avoids repayment and brings flexibility, but it costs more and reduces
ownership. Most successful companies use a smart mix of both. Choosing the right balance
depends on the company’s size, income, goals, and risk tolerance. When used wisely, both debt
and equity can help a company grow and succeed.

References

Ai, H. A., Frank, M. Z., & Sanati, A. (2021). The trade-off theory of corporate capital structure.
Oxford Research Encyclopedia of Economics and Finance. https://ssrn.com/abstract=3595492

Sitjà Fernández, L., & Serrano, R. P. (2024). How does debt financing influence a start-up’s
growth? Universitat Politècnica de Catalunya.
https://upcommons.upc.edu/bitstream/handle/2117/421817/SITJA_SUBIROS_RP2024_SERRAN
O.pdf?isAllowed=y&sequence=2

Wardiman, J. (2024). Exploring debt financing options for SMEs: A systematic literature review.
International Journal of SME Finance.
https://www.researchgate.net/publication/386378055_EXPLORING_DEBT_FINANCING_OPTION
_FOR_SME%27S_A_SYSTEMATIC_LITERATURE_REVIEW