Comparison of Debt and Equity Financing

The objective to financial managers is to maximise the return on shareholders’ funds at an acceptable level of risk. This means that they must consider:

• The most appropriate debt to equity ratio.
• The relative cost of equity and debt finance.

• The most appropriate mix of short and long-term liabilities in the total debt.

In making these financial decisions, financial managers will consider:

• The terms and costs of each option.
• The tax implications.
• Matching the term and source of the finance to the purpose.
• Business structure.
• Gearing.

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Owner’s equity finance is a residual claim to the business’s assets, that is, owners’ have a claim to the cash flows generated by the business’s activities only after all other claims have been met, for example, those of creditors. The advantages of owners’ equity financing are:

• Subject taxation considerations, self-funding of capital by using retention of profits in the business may be the simplest and most economical method, in terms of costs of funds.

• It has the advantage of no dilution of ownership, because nobody from outside the business entity is involved in the funding. Rather, it is the owners who have not taken their full profit share.

• No borrowing has taken place to obtain the extra funding. Equity finance does not have to be repaid and there are no interest payments or other obligations that have to be met.

• Equity funds are of unlimited duration. No outside influences determine the life span of these funds in normal circumstances and so they are ideal for very long-term investments.

Disadvantages of owners’ equity financing include:

• Equity funds are also required to absorb losses, which is entirely within the shareholders’ funds area of the Balance Sheet, and without substantial reserves of equity, no company can sustain losses for long. One of the problems faced by new, and also established, small businesses is that their equity bases are too small. If there is under-capitalisation, they are unable to carry the early losses usually sustained by new ventures. As new, or small, ventures they are high-risk businesses, making them less attractive to lenders and forcing them to rely on owners’ equity funds.

• Equity financing is more costly than debt financing because it is necessary to earn sufficient profits to pay non-tax-deductible dividends while retaining sufficient profit to fund future growth.

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Debt finance is raising funds by borrowing. Debt financing has the following advantage:

• It is tax deductible from income. Tax savings from the use of debt increases in periods of high inflation, such as occurred in the Australian economy during the 1970s and 1980s. Debt is cheaper than equity. In this case of debt funding, the return to the investor is paid as interest. This is accounted for before taxation on profits, and thus for every $100 interest paid, within a company tax rate of say 35 per cent, the effective cost of funds to the business is $70. On the other hand, with equity funding, the return to the investor is in the form of dividends. These are profit sharing, after tax. So the actual payment of $100 is not reduced by taxation allowances. A further consideration is that higher risk usually calls for higher interest or return. A shareholder is at total risk in that not only might no dividend be received, but other creditors rank ahead of a shareholder in final distribution of assets. So we may say that if the business is paying interest rates of 8 per cent, then an at-risk shareholder may be expecting dividends of say 12 per cent. Debt funding is therefore very much cheaper to the business entity than equity funds.

The main disadvantage of debt financing is:

• It increases the financial risk of the borrower.

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Gearing, or leverage, is the ratio between long-term debt and equity in the Balance Sheet of a business entity.

                                       Interest-bearing debt
Debt to equity ratio =  ----------------------------- x 100
                                          Owners’ equity

The lower this ratio, the lower the gearing. Thus a company with $1 000 000 in long-term debt funding, and $10 000 000 in shareholders’ funds has a gearing ratio of 10 per cent. This company is in a strong position with its debts covered nine times over by the shareholders’ funds. The lowest gearing would be 0 per cent, while the highest is unlimited, though in practical terms, an investor would be very concerned about a company with a gearing over 75 per cent. The ideal gearing does not exist. Rather it will vary from entity to entity, and from time to time within the same entity. However, the type of industry in which the business operates has influence on the appropriate debt to equity ratio.

The appropriate debt to equity ratio can have a significant effect on earnings per share and the capacity to pay dividends to shareholders. Earnings per share (EPS) is calculated by dividing the company’s net operating profit after tax by the number of shares on issue. What the investor actually receives is known as dividend per share, which is the proportion of earnings actually paid to shareholders.

                                             After-tax profit
Earnings per share ratio =  -----------------------
                                            Number of shares

                                Dividend
Dividend yield =  ---------------- x 100
                              Share Price

Properly managed, gearing can be very useful to a company, by only if it is making a return on utilised funds greater than the interest and other charges on the debt funds. If this is not met, the company will inevitably be driven into insolvency. This is another perspective on the risk associated with high gearing – the higher the gearing, the more vulnerable the company is to interest rate movements.

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