Which is cheaper debt or equity financing

Difference: equity & debt

A company can finance itself from equity and debt capital. The differences as well as advantages and disadvantages of both types of capital will be explained in this article.

Definition of equity

Equity is the portion of assets that is left over after debt is deducted. For example, equity is brought into the company through contributions by the shareholders. The equity gives a statement about the ownership shares of a partner. For example, if a shareholder has invested 50 percent of the equity in the company, then half of the company belongs to him. Equity providers are fundamentally involved in profits, losses and corporate governance.

Definition of debt capital

In simple terms, debt capital describes the debts that a company has. In contrast to equity, lenders do not participate in profit, loss or management. However, interest is paid for the temporary provision of capital.

Comparison between equity and debt

The following table compares important features of the two types of capital.

EquityBorrowed capital
Legal relationshipShareholdingDebt relationship
liabilityDepending on the legal form, the partner is liable either with his entire private assets, but at least with his contributionLenders are not liable
RemunerationThe company participates proportionally in the profit and lossReceiving Interest
Co-determinationThe company is fundamentally entitled to co-determinationNo participation provided
AvailabilityBasically for an unlimited period of time, but can sometimes be terminated promptlyLimited
taxationInterest on equity is not tax deductibleInterest on borrowed capital is fully deductible as an expense
interestEquity providers are interested in the maintenance and positive development of the companyLenders are interested in repaying their capital

Advantages of Equity

Equity generally generates higher returns than debt. This is due, for example, to the sometimes high security deposits and interest that banks charge for loans. In addition, equity is available for practically unlimited periods of time, while loans have to be repaid within a certain period of time. However, there are also participation relationships in which the equity investor can terminate his contribution at short notice.

Furthermore, companies that have a high level of equity cover receive more favorable credit terms than companies with a high level of indebtedness.

Disadvantages of equity

In principle, equity providers are entitled to co-determination. This limits the power and flexibility of the previous shareholders. This is why participation is often contractually restricted in practice. As with co-determination, the profit must also be shared with other equity providers.

Advantages of outside capital

In contrast to equity, profits and participation do not have to be shared with the lenders. In addition, the interest payments can be claimed for tax purposes.

Disadvantages of outside capital

Borrowed capital is only available for a limited period of time. Furthermore, the company must meet its interest and repayment obligations even when it is in an economically difficult situation.

Borrowing takes priority, equity is subordinate

Should a company go bankrupt, the debtors' claims will first be satisfied in the insolvency proceedings and only then - if enough funds are available at all - those of the equity capital providers. It is said that debt capital has priority, equity capital is subordinate. Thus, equity investors bear the greater risk of losing their capital. This is why equity investors are particularly interested in maintaining the company.

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