Pros and Cons of Debt and Equity Financing

Now that we’ve talked through the various options for debt financing, let’s go through the list of pros and cons of debt financing. The first pro of debt financing is that interest expense is tax deductible. When we have interest expense, it decreases our taxable income and therefore we pay less in taxes.

The next benefit to debt financing is that it has fixed terms. When we get into debt, we know how much we’re going to pay in interest. We know how long it’s going to last, and we know what happens if we don’t pay the debt. Debt offers a certain degree of certainty.

The next pro to debt financing is that a company doesn’t give up any control whenever it issues debt. Whenever it finishes its last payment, it no longer has any obligation. Contrast this with equity financing, where we give up control of the company.

The next pro for debt financing is that it is less costly than equity. Even though there may be some initial fees, the fees for debt financing are much less than the fees for equity financing.

Now let’s transition to the cons of debt financing. The first con is that regardless of how the company is performing, it still has to make its debt payments. If suddenly the company loses all of its customers, it still has to make the payments. Whereas with equity, a company could choose just to not issue any dividends if it’s financially suffering.

Another con of debt is that some loans require loan covenants. Loan covenants are certain requirements that a bank sets for a company. Loan covenants aim to prove that a company is in a good financial position and that it’s capable of paying off its debt. The first kind of loan covenant is called a positive loan covenant. These are requirements that a company must meet to maintain its debt. For instance, a bank may require a company to maintain a current ratio of at least two.

The next con of debt financing is that if a company is too dependent on debt (i.e., it has a high debt-to-equity ratio), then a bank may view the company as too risky and not provide Financing.

A negative loan covenant specifies what a company must not do. For example, a bank may tell a company that it is not allowed to get any additional financing from other banks.

In summary, we can see that debt and equity financing each have their unique characteristics,benefits, and consequences. Consider the summary of each method below.

Pros of Debt Financing:

Interest paid on debt is tax-deductible

Debt has fixed terms

A company doesn’t give up ownership when it issues debt

Debt is less costly than equity

Cons of Debt Financing:

A company has to make interest payments no matter how it is performing

A business too highly dependent on debt may not be able to acquire additional debt funding

A company has to adhere to loan covenants

Pros of Equity Financing:

Don’t have to pay back money like with debt

No interest payments

For common stock owners, the company gets to decide the amount of the dividend to issue each year,or even not issue any dividend

Cons of Equity Financing:

Common stock gives up ownership of the company

Issuing dividends are not tax-deductible

Equity financing is more expensive than debt financing