EQUITY CAPITAL VS DEBT CAPITAL
Manynew business owners are often confused between debt capital andequity capital. This article provides an explanation of thedifference between these two types of capital. Capital is thedifference between total assets and liabilities - it is the totalvalue of a business at the end of a period of time. Equity, on theother hand, represents the amount of total assets less the totalvalue of the assets at the end of that period of time - equitycapital represents the value of a business less the value of theshares that control that business. Most businesses will have debt andequity - and it is common to see a combination of both. However,there can be differences in the manner in which these two types ofcapital are used.
USEOF CAPITAL IN LARGE PURCHASES
Acommon example of the use of debt capital is in the purchase ofproperty for use as collateral for loans. When a bank loans money toa business, the business receives a certain amount of capital as wellas a promise to pay back the loan. In return, the bank receivesinterest and other benefits. Typically, banks use debt capital tomake large purchases that create a large cash flow. They may useequity capital, however, to make small purchases that create asmaller cash flow.
PREFERREDCAPITAL FOR SMALL BUSINESS
Manysmall businesses start out by issuing debt capital. This allows themto purchase property without paying back the full amount of the loanuntil they have created a sufficient cash flow to repay the loan. Asthe business grows, more debt capital is required to continueoperations until a point at which the company has achieved enoughcash flow from its operations to pay back the loan completely. As thecompany continues to expand, more equity capital is required to makefurther purchases and spread the costs over a larger number ofprojects.
Itis common for businesses to use both equity capital and debt capital.For example, many restaurants will use their equipment, inventory,and facilities to make up the difference between their start up costsand end sales. In order to remain profitable, a business must be ableto turn a profit. The lower their cost of doing business, the greatertheir profit margin will be.
Whileequity capital provides a borrower with a lump sum of cash to financethe purchase of property or equipment, debt capital is a loan wherecollateral is provided by the company against the equity in thecompany. If the company defaults on the debt capital, the borrower isnot required to provide security. Equity capital is considered lessrisky than debt capital because it is typically supported by theassets of the company. However, if the company were to default, theequity would suffer the same losses as debt capital.
USEOF EQUITY CAPITAL BY PROPERTY DEALERS
Inaddition to purchasing property or equipment, many businesses use theequity capital to obtain working capital loans. Working capital loansare required when a small business needs money to meet short-termfinancial obligations. This type of financing allows the borrower totake advantage of the benefits of credit while at the same time beingprotected from the dangers of credit. Working capital loans areusually based on the equity value of the entire company and arerepaid upon the borrower's discharge from the business.
RISKFACTOR IN BOTH CAPITALS
Inorder to determine whether debt capital or equity capital is betterfor the company, it is important to understand the risks involved ineach. Debt capital represents a loan where the risk of default ishigher than that of an equity loan. This means that the borrower willhave to wait to get paid the full amount of the loan. On the otherhand, equity capital represents a loan in which the risk of defaultis much lower than that of debt capital.
Todetermine whether debt capital is better for a business, it isessential to first determine its cost. A company's cost of capital isthe excess of earnings over cost of capital divided by net assets.Net assets represent the value of all current and tangible assets.The difference between equity and debt capital is the amount of cashneeded to finance the business. Therefore, if a company needs moremoney to expand, debt capital is preferable.