Pros and Cons of Debt and Equity Financing
Kyle Ashcraft, CPA · 2019 CPA Exam Scores · 95 FAR · 98 BEC · 91 REG · 90 AUD
Every company raising capital chooses between debt and equity, and each comes with real trade-offs. Here's what actually favors debt, what favors equity, and where loan covenants fit in.
What are the pros of debt financing?
- Interest is tax-deductible — interest expense reduces taxable income, so a company pays less in taxes
- Fixed terms — you know the interest rate, the payoff timeline, and what happens if you don't pay, which gives debt a degree of certainty equity doesn't have
- No loss of control — once the debt is paid off, the company has no further obligation; equity financing means giving up a share of control permanently
- Lower cost — debt financing typically carries lower fees than issuing equity, even accounting for upfront costs
What are the cons of debt financing?
- Payments are mandatory — regardless of how the company is performing, debt payments still come due. Equity is more flexible here: a struggling company can simply choose not to pay a dividend
- High leverage limits future borrowing — a company with a high debt-to-equity ratio looks riskier to lenders, who may decline to extend further financing
- Loan covenants — lenders often attach conditions to a loan to confirm the company can actually repay it
What are loan covenants?
A positive (affirmative) covenant requires the company to do something to maintain its debt — for example, a bank might require the company to maintain a current ratio of at least 2.
A negative (restrictive) covenant prohibits the company from doing something — for example, a bank might prohibit the company from taking on additional financing from other lenders.
What are the pros and cons of equity financing?
Equity financing flips most of debt's trade-offs: no repayment obligation and no interest payments, and for common stock, the company decides each year whether to pay a dividend at all — or skip it entirely. The cost is real, though: issuing equity means giving up a share of ownership, dividends aren't tax-deductible the way interest is, and equity is generally more expensive to raise than debt.
| Debt Financing | Equity Financing | |
|---|---|---|
| Pros | Tax-deductible interest; fixed terms; no loss of control; lower cost | No repayment obligation; no interest; discretionary dividends |
| Cons | Mandatory payments; high leverage limits future borrowing; loan covenants | Dilutes ownership; dividends not tax-deductible; higher cost |
Debt is cheaper but rigid; equity is flexible but dilutive. Debt payments don't bend to the company's performance, while equity's cost is giving up a permanent share of ownership and control. Most companies use some mix of both rather than relying on either exclusively.
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Kyle Ashcraft, CPA scored 90 or above on every section of the CPA exam in 2019, including a 98 on BEC. He is the founder and sole instructor of Maxwell CPA Review, a complete CPA review course covering all six sections, where he creates every lecture, textbook and study outline himself.