Equity or Debt? Choice of Preferred Financial Mix

Financial mix often consists of two important sources of finance: equity and debt. Most companies use bank loans, bonds and debentures as part of their debt capital. On the other hand, equity can be raised through preference shares, venture capital, and private equity funds.

When choosing the right balance between debt and equity, one must consider the risks and benefits involved in each option. Debt is appropriate when the company does not want its ownership to be diluted. Using debt as a method of raising finance also has tax advantages to the business. However, it may lead to bankruptcy if the business does not honour its debt obligations. Equity has less risk of bankruptcy because the company does not need to repay it.

To maximize the value of your business, you should try to find a financial mix that minimizes both the cost of capital and the risk of bankruptcy. Your capital structure can quickly be evaluated by calculating your debt-to-equity ratio. This ratio refers to the proportion of debt in the company’s capital structure as compared to the proportion of equity.

The degree of stability in your business, its ability to provide suitable collateral as security, the interest rate you are charged as well as legal or contractual restrictions on debt are all factors that will influence your optimal debt-to-equity ratio.

For example, a company operating in an unpredictable business environment where a future downturn could impact its ability to repay lenders should have a low debt-to-equity ratio.

Conversely, a company with long-term capital assets, such as buildings or equipment, and predictable cash flows can be more highly leveraged.

The optimal debt-to-equity ratio may vary from one industry to another, but the general consensus is that it should not be above a level of 2.0. This means that debt contributes two-thirds of the company’s financial mix. It also means that the proportion of debt in the capital financing mix of the company is twice that of equity. Most managers suggest that debt should not be more than twice the amount of equity.

While some very large companies in fixed asset-heavy industries (such as mining or manufacturing) may have ratios higher than 2, these are the exception rather than the rule. The less the value of the debt-equity-ratio, the better for the company. It is important to have more equity in the capital structure, but too much of it also dilutes the company’s ownership.

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