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Debt or Equity? We say, a combination of both.

Updated: Mar 13, 2023

No two businesses are alike,

and neither are their funding requirements; however, all organizations need a sustainable capital structure to expand and produce returns. Unfortunately, achieving the ideal capital balance can be tricky.

There is no getting around the fact that companies need to create a sustainable capital structure if they want to exist and thrive. That's because a company's capital structure ensures that there are many doors left open for that organization to pursue new and ambitious growth opportunities in addition to helping treasurers consolidate a company's financial strength.

The ideal capital structure should also give businesses the flexibility they need to weather any unforeseen economic downturns that may occur. However, for most corporations, finding and maintaining the ideal capital structure can be a challenging balancing act.

Capital structure balance is typically maintained by establishing a company-tailored balance of debt and equity. Both of these funding options have complementary advantages, so the vast majority of treasurers invest a lot of time and effort into combining the two to make sure their respective organizations are adequately funded to achieve any particular long-term goals.

Unfortunately, a business cannot establish perfect financial harmony using a magic formula. Sure, there are general recommendations for a company's ideal debt-to-equity ratio, but ultimately, each company must carefully weigh the advantages and disadvantages of debt and equity in order to find the ideal balance that is suitable for their particular business.

While there may not be any universal benchmarks that treasurers should strive for in their never-ending quest to create a healthy capital balance, there are a few broad considerations that are definitely worth bearing in mind.

But first, what’s the difference between debt and equity capital?

While both debt capital and equity capital are equally important components of a company's capital balance, there is little to no overlap between the two funding strategies beyond that.

Debt capital refers to the money a business has borrowed from a lender to fund operations that will eventually be repaid. This borrowing typically occurs in the form of long-term commercial loans or a diverse range of short-term alternative funding strategies, including crowdfunding, borrowing from friends and family, invoice financing, revenue-based financing, and more.

Debt capital has the advantage of not diluting a company's shareholder interest. Debt has been a very alluring way to generate quick cash to fund growth because of its lower cost of capital.

Another point worth considering is that payments towards debts or interest paid on debts are normally tax deductible in the vast majority of regulatory jurisdictions.

By contrast, "equity capital" specifically refers to the funds paid into a business by shareholders. This makes the cost of equity a bit more complex, although it normally takes the form of common stock, preferred stock, or retained earnings. That means equity is a reflection of ownership, whereas debt is a reflection of liability. It also means that by taking on loads of equity, shareholders will inevitably be diluting their overall ownership of the company.

Equity is often considered a great way to fund a business because it enables companies to power strategic initiatives and strengthen working capital without taking on new debt liabilities. That being said, equity financing does come with the added pressure of investor expectations around returns and market performance.

So, what is the best way to balance capital?

All treasurers should aim to minimize their company's weighted average cost of capital (WACC) when attempting to establish and maintain a sustainable and effective capital balance. Any increase in WACC will subsequently indicate a decline in company value and a concomitant rise in risk for both lenders and investors.

"The weighted average cost of capital is a more important measure for companies that are looking to expand, make acquisitions, and raise capital."

This is because it is a more accurate measure of a company's true cost of capital.

Additionally, treasurers must monitor their company's debt-to-equity ratio.

It's fair to say that most corporations aim for a maximum ratio of 1:2, in which the value of equity capital is double the amount of debt capital, even though different ratios work for different companies.

Many financial professionals advise doing this because a significantly higher percentage of equity guarantees that the organization will be able to effectively and sustainably cover any losses incurred.

However, if companies go any higher in terms of equity, shareholders' power may be weakened, and returns may decrease in line with that reduced authority.

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