The main goals of business are to make profits and increase their investor’s wealth. For achieving these goals, finance acts like blood for any organizations to continue their business operations in efficient manner. Finance can be made available through two main sources
– Equity
– Debt
These both areas are distinguished below separately
Equity: Generally, the term equity related to the ordinary shares only. Equity finance is the investment in an organization by the organization’s shareholders, represented by the issued ordinary share capital plus reserves. There are also other parts of share capital like “preference shares” but those are not treated as equity because their characteristics are related to debt finance. Equity finance can be raised through three main sources. The first source is internally generated funds also named as retained earnings. These are the earnings retained in the business (un-distributable profits to ordinary shareholders).The main advantage of raising finance through retained earnings is that, it is cheap and quick to raise and requiring no transaction cost. The second main source of equity finance is right issues. Right issues are simply an offer to existing shareholders to subscribe for new shares at a discount to the current the current market price. The main advantages to right issues are that it rarely fails and it is cheaper than a public share issue. The third main source of raising equity finance is to issue new shares to public. Large amount of finance can be generated through new shares issue but on the other side, it is much costly than other sources of equity because it require heavy transaction costs and some other professional fees.
Debt: Debt finance, usually in the forms of debentures, bonds or other loans used as a source of finance as an alternative to equity. Debt can be in many forms like Bank loans, Loan notes and Redeemable or Irredeemable debt. There are many advantages of debt finance. Like, Form the point of view of investor, debt is low risky. And from the point of view of organization, debt is cheap, does not dilute control and has predictable cash flows. On the other side debt finance has also some disadvantages like, form the point of view of investor debt has no voting rights and form the point of view of the organization, debt is inflexible and increases the risk at high levels of gearing.
Main differences between Equity finance and Debt finance:
The main difference between equity and debt is that, the debt is treated as the cheap source of finance because it is less risky than Equity. The repayment of debt takes priority over all other equity investments. On the other side of coin Equity finance is considered are a risky and costly source of finance because for some large Investments, Internally generated funds are not sufficient. And issuing new shares requires extra costs (mentioned above). In short there is a strong need for any organization to maintain a balance between these two main sources of finance to perform and support their business in efficient manner.