Whether a company should be financed with equity or/and debt is not always clear right away. Which of the two forms of capital is more advantageous for a company depends on a number of factors. Therefore, comparing the advantages and disadvantages can be helpful in assessing the company’s capital needs and choosing the right financing solution.
In the following guide, we would like to give you an overview of the advantages and disadvantages of the two forms of capital and explain what is important when choosing the form of financing.
Definition: What is equity?
Equity is the portion of a company’s capital that remains after deducting all debts and liabilities and represents net assets. Equity capital is financial resources that are made available to the company by the shareholders or investors or that have been left in the company as earned profit to strengthen the equity ratio. Equity includes bank deposits, shares and real estate. It is available to the company for an indefinite period and is not subject to interest or repayment.
When a company is founded, equity capital is created through cash and non-cash contributions by the shareholders, which at the same time provides information about their ownership interests in the company: In the case of a stock corporation (AG), the equity capital must amount to 50,000 euros, in the case of a limited liability company (GmbH) 25,000 euros and in the case of a business corporation (UG) 1 euro.
Within the company, however, equity can fulfill many functions and often serves as a basis for liability to creditors. In order to increase equity, shareholders sell shares in the company to investors, which also makes them shareholders.
Characteristics of equity:
- Unlimited
- No interest
- No fixed terms
- no claim for repayment
- Basis of liability towards creditors
- Equity investors have decision-making power, profit-sharing and participation rights
What are the types of equity?
According to the Commercial Code, there are different types of equity:
- Subscribed capital: Legal entities (e.g. corporations) are obliged to pay in equity capital as a capital contribution when founding a company. This contribution results in the subscribed capital.
- Capital reserves: they are kept as a security and financial reserve for a later date.
- Retained earnings: Includes reserves under the Articles of Association, statutory reserves, reserves for company shares and other reserves.
- Profit or loss carried forward: Equity is formed from the profit of the previous year.
- Net income or net loss: This is the entrepreneurial profit after deduction of all applicable taxes.
Functions of equity
As already indicated, equity fulfills many functions in a company.
- Liability: Protection and liability basis for creditors; the company is liable with its equity.
- Start-up function: Equity is of great importance when starting a business. Only with the necessary equity capital can investments be made and business operations commence.
- Financing function: A high equity ratio enables the company to obtain better conditions when obtaining a loan.
- Loss absorption: Losses can be better absorbed by equity.
- Risk coverage: The equity ratio influences how high the maximum bearable losses of a company are
- Profit distribution ratio: The distribution ratio of profit to investors is based on the amount of equity contributed.
- Representational function: The share of equity in total assets has a high promotional effect. The higher the equity ratio, the higher the credit rating of a company.
- Domination and hierarchy: The higher the equity, the higher the say of the capital providers.
Equity through internal and external financing
Companies can obtain equity capital through internal or external financing. Self-financing is also referred to as internal financing, as it usually comes from the surpluses generated by the company. If the entrepreneurs contribute equity capital to the company when it is founded, this is classic self-financing. Otherwise, the profit generated in the financial year and retained in the company represents a form of equity. If the profit is retained in the company at the end of the year, the operating assets increase and the equity increases.
However, if the equity comes from outside the company, it is referred to as external financing by equity providers. For this purpose, equity investors can be called upon, shares can be issued or new shareholders can be taken on. Thus, the capital comes from the outside.
What does self-financing mean?
If a company finances itself from its own resources, this is referred to as self-financing or self-financing , as the capital is used from the company’s assets. In this case, the company does not borrow outside capital via a loan.
A company can resort to different forms of financing, one of which is self-financing. Those who do not resort to outside capital (e.g. a bank loan) finance new investments with equity. If the company can finance itself from its own resources, equity increases, which in turn has an important influence on the success of the company. On the other hand, it also represents a risk as soon as equity is lost, because the equity ratio then falls and with it liquidity and creditworthiness.
What rights do equity investors have?
Equity investors, in contrast to debt investors, participate in the profit and loss of the company. They leave their financial resources to the company for an indefinite period and receive shares in the company in return. Depending on the legal form, these may be shares in a GmbH or shares in an AG. This provides equity investors with various rights.
In the event of insolvency, however, equity investors have to bear more risk than debt investors because they are subordinated, i.e. the available capital is repaid first to debt investors and only then to equity investors. Investors are therefore only willing to finance a company if the company has a chance of success and they have prospects of a successful exit. This is the case if the investment can later be sold at a lucrative profit. Corresponding agreements regulate the participation and control rights of the equity investors as well as their rights with regard to an exit(exit-related rights).
Advantages and disadvantages of self-financing
| Advantages of equity financing | Disadvantages of equity financing |
| The risk of over-indebtedness due to loans is lower. | Equity via external financing by equity investors is more expensive than debt in the long term due to risk premiums. |
| The risk of insolvency or bankruptcy is lower. | Equity financing is not tax deductible. |
| More independence and decision-making freedom for the company. | Less independence in the case of equity financing through external financing, as equity investors have co-determination and profit-sharing rights. |
| Better equity ratio and provides better opportunities for debt financing. | Distributions reduce the company’s earnings. |
| Enables the company to achieve higher profits. | Higher personal risk of entrepreneurs. |
| Equity is available for an unlimited period of time. |
When does self-financing make sense?
Equity financing always makes sense when long-term assets (e.g. buildings, land, machinery) need to be acquired. Ideally, financing is low-cost so that long-term values can generate profits. Machinery and buildings can have a direct impact on the operating result and generate profits; in the case of debt financing, interest and repayments must first be paid, which in turn reduce profits.
If a company has a lot of liquid funds that are not directly earmarked for operational use or distribution to stakeholders, it may be worthwhile to make planned investments with its own capital. However, it may also be advisable to take out a loan or apply for a lease for part of the investment, as this can ensure that entrepreneurs continue to have flexibility over their own available funds. In contrast, debt financing is a good choice when new opportunities arise for growth projects for which capital is needed in the short term. Especially for this purpose, fulfin’s alternative financing solutions are useful.
Definition: What is debt capital?
Together with equity, debt capital forms the company’s total capital.
In simple terms, debt capital(outside capital) is capital that comes from other capital providers and is raised via a loan. It is usually fixed-term and interest-bearing. From a business perspective, debt capital is the opposite of equity capital and refers to the debts – liabilities and provisions – of a company. Accordingly, this is the part of the capital that does not belong to the owners themselves, but to third-party capital providers (creditors). Unlike the equity investor, the debt investor has no participation or control rights or profit-sharing.
Characteristics of debt capital:
- fixed-term with fixed terms
- Interest and repayment rates
- Entitlement to repayment; priority over equity capital
- Expenses can be claimed against tax
- Lenders have no decision-making power or profit participation
What are the different types of debt capital?
According to the German Commercial Code (HGB), there are the following types of debt capital:
Provisions:
Accruals are all uncertain liabilities that are expected but whose amount and existence cannot be determined at the present time.
- Provisions for pensions (company pension scheme for employees)
- Provisions for commissions or contingent losses
- Tax provisions (e.g. corporate income tax, trade tax, sales tax)
- other accruals
Liabilities:
Liabilities are financial obligations of the company to third parties (creditors).
- Liabilities to banks or other credit institutions (credit, loans)
- Trade payables (VLL): trade payables and outstanding invoices.
- advance payments received for services that will not be rendered until a later date.
- Bonds
- Liabilities from bills of exchange accepted and own bills of exchange issued
- Liabilities to affiliated companies
- Liabilities to companies in which an equity investment is held
- Other liabilities and debts, of which taxes and social security contributions
Deferred income: Revenue is recognized but performance will not take place until the next fiscal year.
Deferred tax liabilities: Taxes whose asset items are recognized in the commercial balance sheet at a higher amount than in the tax balance sheet or whose liability items are recognized in the commercial balance sheet at a lower amount than in the balance sheet.
A further distinction is made between borrowed capital and repayment dates:
| short term | medium-term | long-term |
| Short-term debt financing must be repaid within 12 months (e.g. outstanding supplier invoices). | Medium-term debt financing must be repaid after one year, but at the latest after 5 years (e.g. maturity loan). | Long-term debt financing must be repaid after more than 5 years (e.g. bank loans, pension provisions). |
Calculate the debt ratio
In addition to the equity ratio, the debt ratio also provides information about the company’s financial situation. With a high equity ratio, a company receives better conditions for debt financing via a loan; in contrast, a high debt ratio has a negative effect. In the case of the debt ratio, the
Formula for the debt ratio:
Debt ratio= DebtTotal assets Total capital*100
The lower the debt ratio, the more financially independent and strongly positioned the company is. It is financed primarily from its own resources. High debt ratios reduce profits despite a stable corporate situation due to high interest and repayment expenses.
Example:
A company has total assets of 250,000 euros and borrowed capital of 50,000 euros.
Debt ratio=Borrowed capitalBalance sheet total = 50,000 euros250,000 euros*100=20 %
The debt ratio is 20%.
What are the advantages and disadvantages of debt capital?
| Advantages of debt financing | Disadvantages of debt financing |
| Profits do not have to be shared with the lender. | |
| Lender has no right of co-determination; more freedom of action for the company. | The Company must meet its interest and repayment obligations even in economically difficult situations. High risk of over-indebtedness. |
| Interest on borrowings can be deducted as an expense for tax purposes. | In the event of over-indebtedness, insolvency is imminent. |
| Borrowed capital is only available for a limited period of time. | High debt ratios entail disadvantages for the company. Companies with high equity ratios are preferred for debt financing. |
| Equity is more expensive than debt, so it can be more lucrative for a company to have a lot of debt. Borrowing costs are tax deductible in many countries, but equity costs are not. | As the leverage ratio increases, so does the risk of insolvency. |
What is the difference between equity and debt?
In the case of equity financing in the context of external financing, the investor has a direct stake in the company and benefits from co-determination rights and profit sharing. They are entitled to receive information about the company and have the opportunity to influence the company’s activities by having a say.
The situation is different for a debt investor, as he receives remuneration in the form of interest for providing the capital and has no direct involvement or say in the matter. The company can continue to act independently and use the funds provided within the framework of the loan agreement covenants. However, certain forms of debt financing also allow capital providers to benefit from agreed profit withdrawal and sales proceeds rights.
| Equity | Borrowed capital | |
| Legal relationship | Equity investment relationship; equity investor is owner | Debt relationship; lender is creditor |
| Liability | Capital provider is liable with his contribution or with his private assets | Capital provider is not liable |
| Charge | Participation in profit and loss | Remuneration by interest |
| Co-determination | Entitled to co-determination | No co-determination |
| Right to information | Can view information about the company | Can only view key information |
| Participation | Participates in increase in value; profit sharing | Not participating in value appreciation; no participation in profit |
| Availability | Unlimited in time and can be partially terminated in a timely manner. | Time limited |
| Taxation | Interest on equity is not tax deductible | Interest on borrowed capital is tax-deductible as an expense |
| Interest | Equity investors have an interest in the preservation and positive development of the company | Lenders are interested in the repayment of their capital |
| Priority | Has subordination in insolvency proceedings | Has priority in insolvency proceedings |
A hybrid form: mezzanine capital
A special form or hybrid between equity and debt financing is mezzanine capital.
These include:
- Silent partnerships: Silent partnerships constitute a debt relationship and are therefore regarded as debt.
- Profit participation rights: Profit participation rights are also classified as equity in the event of a conditional repayment obligation in the event of liquidation and are taken into account as equity by banks.
- Hybrid bonds: Hybrid bonds are subordinated corporate bonds with a very long or unlimited maturity. They are classified as debt.
- Shareholder loan: From a formal point of view, shareholder loans are debt capital and are classified as a subordinated claim in the event of insolvency proceedings, but from an economic point of view, the shareholder loan is treated as equity.
- Subordinated loan: The subordinated loan is debt capital that does not have to be repaid until the claims of senior creditors have been settled. This type of debt capital is particularly suitable for financing real estate projects, as banks classify mezzanine capital as equity, allowing companies to benefit from better terms for a loan.
The cost of mezzanine financing is somewhere between debt and equity financing. Depending on the negotiated contract, the capital is available as equity over a certain period of time. Similarly, the remuneration for mezzanine capital varies and may consist partly of interest and partly of company participation in the form of subscription rights or premium payments.
Why should a company use debt capital?
Start-ups and small or medium-sized enterprises in particular usually require outside capital in order to be able to set up or expand. Whenever there is a short-term to long-term financing requirement, debt capital is usually used. In the e-commerce sector, short-term debt financing in the form of purchase, inventory or merchandise financing is helpful in bridging liquidity bottlenecks. fulfin also offers customized financing solutions for e-commerce.
Compared with equity financing through external financing (e.g. equity investments), debt capital has the advantage that it is readily available and does not grant the providers of debt capital any participation rights or profit-sharing rights. Thus, debt financing retains a certain degree of independence and financial room for maneuver for the company. Furthermore, companies can benefit from the leverage effect if the interest on external financing is lower than the return generated by equity. Thus, borrowing increases the prospects for profits.
Conclusion
When determining a financing need and choosing the right solution, it is important to accurately assess the equity and debt ratios. If there is not enough equity capital in the company or if there is a short-term financing requirement, debt financing can certainly be helpful in realizing the entrepreneurial plans. Not only founders, but also established companies need to understand and be able to classify the relationships between debt and equity. Only then can they decide whether equity or/and debt financing is the right choice for them.
Here, a healthy combination of different financing solutions can ensure a broader spread of risk. Balanced financing is important for every company in order to secure and guarantee the company’s success in the long term.
FAQ – Equity or debt capital?
What is part of equity?
Equity is generated by a company itself; it is therefore referred to as equity financing or self-financing when a company finances itself with its own funds, i.e. uses capital from the company’s assets. It can completely dispense with borrowing via a loan.
What is included in debt capital?
If a company cannot finance itself from its own resources, it requires outside capital from other capital providers, i.e. a loan must be taken out. In the balance sheet, debt capital refers to the debts – liabilities and provisions – of a company. Equity and debt together make up the company’s total assets.
Can equity be negative?
Yes, equity can also be negative. According to the Austrian Commercial Code (UGB), negative equity exists when equity is consumed by losses. Thus, we speak of “negative equity” when the assets are less than the liabilities. If debt capital outweighs assets, the company is indebted. Accordingly, equity is always positive if the asset side of the balance sheet is greater than the liability side.
What are the advantages of debt capital?
Borrowing has many advantages for companies and can strengthen liquidity – depending on requirements – in the short or long term or make tied-up liquidity available (e.g. inventory financing). Also worth mentioning would be the tax advantages that arise from debt financing, since the interest to be paid is recognized as an expense and reduces the tax burden. In principle, however, debt capital offers a company more self-determination and scope for investment, provided the investor has no right of co-determination (see mezzanine capital).
What are the risks associated with debt capital?
Of course, debt capital or debt financing can also entail risks. If an unplanned development of the company or investment takes place, debt financing can become a risk and, in the worst case, endanger the existence of the company. Many insolvencies are due to excessive debt financing.
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