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Merits And Demerits Of Equity And Debt Financing

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May 12th, 2011
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There are two main sources of raising capital for a business. (1) Owners and Creditors. The original funds invested by the owners plus profits retained in the business is called owned Capital or Equity Finance. The capital which is provided by creditors is called borrowed capital or debt finance. The merits and demerits of equity finance and debt finance are now discussed in brief.

Merits of Equity Finance
(1) Permanent source of capital. The equity finance is a long term capital available to the business. The question of repayment arises only when the company is winded up.

(2) No payment of interest. The business concern has not to pay interest charges on equity capital.

(3) Improved ability to face business recession. As there is no burden of fixed interest charges on equity capital, the business concern can withstand a business slump better than one that uses debt.

(4) Freedom from financial worries of borrowing. When a business concern finances its operations from funds invested by owners it has then not to depend upon borrowed capital which may or may not be available to a business at the time of need. The business concern thus has a freedom from the financial worries of borrowing.

(5) Earnings remain with the firm. When the funds are provided by the owners for investment in business the earnings of the enterprise remain with the owners. It is not shared with the creditors who have a prior claim of payment in the form of interest.

(6) Liquidation of assets. In case a business is liquidated the assets of the business remain with the owners.

(7) Repayment of funds. A business financed by equity capital has no obligation to repay the funds during the course of a business.

(8) Financial base. The funds supplied by owners provide a financial base to the capital structure of a business.

(9) Ability to borrow. If a business is financed well with equity capital, its ability to obtain borrowed capital in improved.

1. Disadvantages of Equity Financing.
The main disadvantages of equity financing of a business are as follows:-

(1) Idle cash balances. If a business is faced at any time with a period of low activity (slump), then a part of the equity capital remains unutilized. The business will not be earning income on this idle or unutilized cash balances.

(2) Over capitalization. If a company issues more equity shares than actually required by it, it is then likely to result in overcapitalization.

(3) Weak control. In case a company mainly raises its capital by issue of equity shares certain group of equity shareholders may manage to get its board of directors elected. This may be against the ‘goodwill and interest of the company. A continuous struggle between various groups weakens control and the company eventually suffers.

(4) No advantage of borrowed capital. If a company issues only equity shares and does not borrow (trade on equity), it then loses the opportunity to obtain capital at low rate of interest as well as the chance to increase profits in prosperous periods.

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