CEOs have one job, to deploy company capital in a way that grows the company. To do this, they have a choice to make, use debt financing vs. equity financing? Whichever choice they choose goes a long way towards the continued profitability of their company.
Ratios such as return on equity, capital, or invested capital help investors find great capital allocators. They can tell us how efficiently the company uses its assets to grow cash flows. The structure of each company is unique, and the use of debt financing vs. equity financing will depend on each company’s capital structure and where they are in their life cycle.
Warren Buffett waxes eloquently in his shareholders about the benefits of looking for great capital allocators and assessing those by looking at efficiency ratios such as returns on equity or capital.
Buffett believes that successful investments result from a strong, underlying business, with the value stemming from the ability to generate growing cash flows each year. He tries to find management that can deploy their capital efficiently that offer greater returns for shareholders.
In today’s post, we will learn:
- What is Debt Financing?
- What is Equity Financing?
- Pros and Cons of Debt Financing vs. Equity Financing
- Is Debt Financing Riskier Than Equity Financing?
- Investor Takeaway
Okay, let’s dive in and learn more about debt financing vs. equity financing.
What is Debt Financing?
Debt financing is a company’s process to raise funds for working capital or other capital expenditures by offering debt to individual investors or institutions. These debt offerings come in bonds, which the company offers in exchange for the investor’s money. These bonds guarantee a full return of their invested capital, along with regular interest payments.
For example, an investor might give a company $1000 for a company’s bond; in return, the company guarantees the return of that $1,000, along with an interest payment every six months for the length of the agreed investment, typically 10 to 30 years.
Once the investor buys the bond, they become a creditor of the company, with the company’s promise to repay the initial capital ($1,000) plus interest payments on that debt.
A common use of debt financing is in the area of mergers and acquisitions. Many companies will offer bonds to investors to raise cash to complete an acquisition. The company’s cash from the investors is used to purchase another company to grow for various reasons, such as increased revenue, larger reach, or better products.
Debt financing involves a cost, and that cost comes from the interest payments to bondholders. That is the cost for the company. If Microsoft offers a bond to investors at an interest rate of 3%, then those 3% interest payments are the cost of debt financing to Microsoft.
It is also the hurdle rate the company must achieve to have a successful investment, whether an acquisition, capital expenditure such as buying equipment, or additional R&D.
If the company’s return on investment or capital is less than the 3% it pays in interest payments, the investment can be considered a failure.
With current interest rates so historically low, there has been an uptick in debt financing through the markets as more and more companies turn to cheap financing to finance their growth. Because the interest rates are so low, companies can offer bonds at low-interest rates that entice investors to grab for yield while offering companies cheap cash to fuel their growth.
That is why it is important to keep at least a cursory knowledge of the current interest rate environment. As rates continue to remain low, many companies will potentially gorge on too much debt financing, and it is important to keep an eye on that activity.
Use measures to check that like the:
They are great resources to help you quickly assess a company’s debt load and determine whether it is straying into dangerous territory. Keep in mind that different industries have different capital structures and can carry higher debt loads. For example, utilities rely on debt offerings to raise funds; the tech world can use either, depending on what works best for each company.
Companies can also use unsecured loans, but that is far rarer in today’s low-interest environment, plus it takes longer to organize.
A key factor to consider with debt financing is that Microsoft has to pay the original investment back to investors. Regardless of the use of funds, that $1,000 investment goes back to the investor, putting pressure on the company to succeed in using the funds.
What is Equity Financing?
Equity financing is the process of a company raising cash by selling its shares. Companies sell their shares for a variety of reasons:
- a short-term need to cover its expenses
- a long-term goal to acquire another company
- invest in capital expenditures to grow the company
When Microsoft, for example, sells its shares, it is exchanging its ownership for the investor’s cash.
Equity financing springs from different sources, the most common is the initial public offering or IPO. An IPO is a process private companies endure to become public by offering their shares on the public market. These public share issuances allow companies to raise capital from investors. Giants such as Facebook, Google, and Square raised billions through their IPOs.
I say endure because the process to go public is quite the ordeal and takes lots of time, paperwork, and due diligence before offering your shares to the public markets.
Other share issuances can come in the form of friends, family, investors, or other companies. Our focus is primarily on public markets, but the same process applies to private companies too.
Start-ups are the most common companies using equity offerings to raise cash, with their short-term needs for lots of cash to operate the business. But, other more mature companies will offer shares as a means to generate cash, such as in an all-stock merger and acquisition. In this process, part of the acquiring company is offered to the acquired company to help sweeten the deal. The share offering dilutes the acquirer’s shares by increasing the share count, but the sale of those shares also grows the equity base.
Equity financing is more expensive than debt financing, especially in low-interest-rate environments that exist today. Equity costs tend to be higher than debt because equity investors demand a higher return than bond investors. The risk of default in the equity world is far greater than bonds, and to compensate investors for that increased risk, they assume a higher cost.
Think of it this way, investing in stocks is riskier than bond investing. While the returns are higher, there is also a greater risk, which raises equity costs.
In the event of a bankruptcy, bond investors are ahead of equity investors in line for a claim on any assets. Any capital gains we might get for equity investments are not guaranteed, whereas bond investing comes with relatively safe returns. The last reason for higher costs is that dividends from equity are not guaranteed, but interest payments are for bonds.
On the plus side, as a shareholder, we have rights to a company’s profits through dividends, share repurchases, or capital appreciation. In some cases, we also have voting rights and could have a say in how the company operates.
Pros and Cons of Debt Financing vs. Equity Financing
Public companies have several choices available to raise capital for any business needs; debt financing and equity financing.
There are several pros and cons to each type of capital financing for businesses, let’s explore them a little:
Pros of Debt Financing
- With debt financing, you are not giving up any control of the company. Equity financing comes with offering shares of the company and potentially putting ownership at stake. With debt financing, ownership is not at stake, and any decisions are solely in control of the management. Likewise, with any profits, they remain with the company and their prerogatives.
- Another pro for debt financing is the limited time frame of the bond offering. For example, after that agreement is over and the debt repaid, the liability ends after the time limit.
- The additional business debt can create tax benefits from tax deductions, which helps expand profitability while the debt is on the books.
Cons of Debt Financing
- The biggest disadvantage to debt financing is the simple fact you have to pay it back at the agreed-upon time. Regardless of your financial situation, there is the matter of required interest payments that eat into profits, and if the company gets on the struggle bus could lead to defaults. Larger debt loads come with increased odds of default, as with our finances.
- Financing can change over time, with variable interest rates in a rising rate environment. That means higher interest rate payments, which could lead to increased unprofitability. If rates go up too much, banks and bond offerings become less appealing to companies and investors.
- Too much debt is never a good thing and can lead to lower valuations and higher interest payments. All of which leads to more volatility in an uncertain market. The higher debt costs also lead to lower profitability, which could filter down to less availability to equity and additional debt financing.
Pros of Equity Financing
- Equity financing has the potential to generate far more cash than debt. By leaps and bounds, equity financing raises more cash for companies. That extra cash can mean life or death to startups as the cash burn is real at the beginning of the company lifecycle. New companies could experience far slower growth without those cash reserves, which is death in the markets. That could have been death for Tesla if Elon Mush had taken Tesla private in the early years; it might not have survived without that access to equity financing.
- A big bonus for equity financing is the flexibility it offers management. Without the burden of interest payments and that constant drain on resources, the company can allocate its capital as it sees fit.
- Another bonus to equity financing is the vested interest owners have in the company being successful. New shareholders want to see the company succeed and will work diligently to ensure that happens. Good equity partners also assist in securing more attractive debt in the future, if needed.
Cons of Equity Financing
- Con number one is giving up control when you issue equity to shareholders. Additional partners can lead to a loss of control on decisions, and in some cases, a hostile takeover and complete loss of control. If the management and board don’t control enough seats on the board, they could lose voting power and decision-making ability.
- Reduced ownership means a loss of potential profits or reduced profits because you have more pieces of the pie to share.
- The biggest con of equity financing is the time required to get it done. Most don’t realize that the time spent trying to raise financing through equity takes an enormous amount of time and effort. Making connections, creating the best sales pitch, and generating enough cash sometimes takes months to years, while debt financing can be a quicker process from soup to nuts.
All in all, there are pluses and minuses to each kind of capital financing a company wants to go through. Each company has different needs, and the way they choose to finance will depend on its needs. Each company can also use a combination of the above methods to raise cash for a capital allocation. It is not uncommon for mergers and acquisitions to be both debt and equity financed.
Both Fiserv (FISV) and Fidelity National Information (FIS) used a combination of debt and equity financing in their recent acquisitions. When they acquired Whole Foods, Amazon used debt financing to generate the cash, plus cash from operations.
A great way to measure the impact each type of financing has on a company’s long-term performance is using ratios such as return on equity or return on invested capital. Generally, the higher, the better, and the bigger spread between the return on equity and the cost of equity, the more value the company creates.
Is Debt Financing Riskier Than Equity Financing?
Debt financing at first seems riskier than equity financing because of the risk of default on the interest payments or the drag on profits from the higher interest payments.
But it comes down to the cost of each and finding a balance between the two that allows a company to remain profitable and grow.
Too much debt can lead to a higher cost of debt for the company, as can too much equity financing as the costs of equity are more expensive.
If the company carries higher equity costs, it makes sense to issue debt to finance any projects. Likewise, if the debt load was burdening the company, equity offerings make more sense. It all comes down to what is best for each company at that particular time.
There are no hard and fast rules saying only debt financing is the best, and vice-versa.
Instead, it is a blend that works best, and investors need to analyze what is best for their investments.
Much of the decisions come down to a few ideas:
- Float costs: this means the bank is offering too high of rates to issue new shares, and debt offerings are cheaper.
- Interest rates: as interest rates rise, debt offerings become far more expensive. The interest rate environment matters and helps determine which method is cheaper.
- Tax rate: here, higher taxes rates eat into bond coupon returns, which means bond investors will demand a higher coupon rate, leading to higher debt costs.
- Earnings volatility: with any earning volatility, the interest payments owed become more precarious and put more strain on the company to ensure enough cash to pay those payments. All of which cuts into the profitability and drives down earnings.
- Business cycle: a young company is in growth mode, and any drag on cash flows leads to potentially lower growth, and issuing equity is a cheaper method to grow in this stage. More mature companies have the financial strength to withstand fluctuations and use debt financing as a means of growth.
Here are Buffett’s thoughts on debt vs. equity financing from his 2017 Shareholder Letter:
“It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments, and savings-minded individuals – to measure their investment’ risk’ by their portfolio’s ratio of bonds to stocks.”
Buffett felt that giving way to debt financing over the long run was a lost opportunity, and that opportunity cost far outweighed the difference in monetary cost.
When analyzing any company, our job is to look through the financials and determine the best use of capital to grow the company and what kind of capital structure the company carries. We also need to assess the capital allocation skills of our CEO and management team because those decisions and their costs go a long way towards greater growth.
And with that, we will wrap up our discussion on debt financing vs. equity financing.
As always, I want to thank you for taking the time to read this post, and I hope it brings some value to you. If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,