Comparing Debt Financing and Equity Financing Essay

Comparing Debt Financing and Equity Financing Essay

Length: 1367 words (3.9 double-spaced pages)

Rating: Better Essays

Open Document

Essay Preview

There are two basic ways of financing for a business: Debt financing and equity financing. Debt financing is defined as 'borrowing money that is to be repaid over a period of time, usually with interest" (Financing Basics, 1). The lender does not gain any ownership in the business that is borrowing. Equity financing is described as "an exchange of money for a share of business ownership" (Financing Basics, 1). This form of financing allows the business to obtain funds without having to repay a specific amount of money at any particular time. There are also a few different instruments that could be defined as either debt or equity. One such instrument is stock options that an employee can exercise after so many years with the company. Either using the debt or equity method, or a combination of the two methods can be used to account for stock options or other instruments with the similar characteristics.

There are pros and cons to deciding to use either of these methods. First I will discuss the pros of using the debt or equity methods. One pro of using the debt method is that it "does not entail 'selling' their equity, but instead works by 'borrowing' against it" (Financing Using, 1). So the company could account for future stock options by assuming that employees will cash the option in, and, in the books, it will look as if they simply have a liability. Another pro with the equity method is that the company is receiving money, and it does not have to pay the money back. In the end the investing company will normally make money on the investment, but it will come in the form of dividends and/or selling the stock back.

There are also a few cons in accounting for these instruments are either debt of equity. "Excessive debt financing may impair your (the company's) credit rating and your ability to raise more money in the future (Financing Basics, 1). If a company has too much debt, it could be considered too risky and unsafe for a creditor to lend money. Also with excessive debt, a business could have problems with business downturns, credit shortages, or interest rate increases. "Conversely, too much equity financing can indicate that you are not making the most productive use of your capital; the capital is not being used advantageously as leverage for obtaining cash" (Financing Basics, 1). A low amount of equity shows that the owne...

... middle of paper ...

...n Shares 400

This would be a very efficient way of accounting for the stock options. There will not be many changes in amounts when the employee has the option. This would be the entry for five years, and then the employee will have their option. Below is the journal entries for both decisions:

Employee takes the cash
Common Shares 2000
Accounts Payable 500
Cash 2500

Employee takes the stock
Accounts Payable 500
Common Shares 500

Again, both methods clear out the accounts payable. Also the employee is receiving the cash or common shares in the right amount.

Debt and equity methods are important decisions when deciding what to do with an instrument like stock options. All three methods, debt, equity, or a combination, are helpful in keeping the books correct and fair until the employee exercises their option. The best method in my mind is the combination of methods. It best shows were the money will go on average before the option is decided on. However the other two methods are also important considering the pros and cons of each decision. No clear answer, however, will ever be known as long as accounting exists.

Need Writing Help?

Get feedback on grammar, clarity, concision and logic instantly.

Check your paper »

Debt vs Equity When Starting a Business Essay

- When starting a business an important question arises, how to finance the company. The steady economic growth combined with low interest rates has produced a lot of liquidity in debt and equity markets. For example, in 2005, non-financial corporate business borrowing increased dramatically to $289 billion, compared to the mere $174 billion it was in 2004 and the $85 billion it was in 2003 (Chung). The outcome of using only debt financing or only equity financing is mostly direct. Businesses run ino the issue when a company’s finance requires both debt and equity characteristics, changing the tax effects greatly (Hanke)....   [tags: finance, equity, accounting]

Better Essays
674 words (1.9 pages)

Long-Term Financing Essay

- Long-Term Financing Long- term financing strategies are used by financial managers to insure that funds invested today will increase in value or stay the same over a stated period of time. This document will compare and contrast the capital asset pricing model (CAPM) and discounted cash flow method (DCF). The debt and equity mix are intended to enable an organization to capitalize on investments. The debt and equity mix will be reviewed as will the characteristics of the financial market and debt and equity instruments....   [tags: Business Finance Investment]

Free Essays
1759 words (5 pages)

The Negative Relationship Between the Debt Ratio and Performance of Firms in China

- Finding According to results of two models, the R square of two models is not high, far lower than 1. So model is not fit the date well, this means that there is not significant linear relationship between the explaining variable and the dependent variable and many factors can affect the performance of firms, however the model don’t take them into consider. In the test of significance, only the DAR is pass the test at the 0.1 significant level. Others variables (current liabilities ratio and surplus reserve ratio) cannot pass the T test at the 0.05 significant level....   [tags: Economics]

Better Essays
1760 words (5 pages)

Evaluating The Risks Involved in Equity and Debt Financing Essay

- Firms around the world rise funds in the capital markets to finance their expansion, acquisitions and other operations. This is usually done through equity and/or debt financing. Equity financing is the process in which a firm raises capital through the sale of shares. Debt financing involves the firm borrowing through, for example by issuing bonds. The firm‘s decision on how to rise capital influences its capital structure and as a result may affect the value of the firm. It is therefore important that the firm must take into account the risks involved in both equity and debt financing....   [tags: business, firms, finance]

Better Essays
1687 words (4.8 pages)

Essay on The Differences Between Debt And Equity

- When it comes to such things as expansion, research and development, or simply building a new manufacturing facility, organizations raise capital in a variety of ways, each with its own unique advantages and disadvantages. In this composition, an attempt will be made to compare and contrast the debt and equity markets, as well as state what type of investor might invest in each market. In the business world, companies finance their operations, both short-term and long-term, in the following three ways: debt financing, equity financing, or profit accumulation....   [tags: Debt, Finance, Bond, Stock]

Better Essays
1024 words (2.9 pages)

Capital Structure Analysis : Financial Risk And Solvency Essay

- Capital structure analysis Liquidity Liquidity is the important meaning of financial risk and solvency. It refers to the extent to which assets can be converted into cash without affecting the asset 's price during normal business operations. Because of the cash flow problem and especially the cash flow problem, many enterprises are bankrupt. As a result, the liquid ratio or the current ratio are used to compare the capacity of the short term debt between the two different companies. At first, the current ratio is a sign of the company 's market liquidity and ability to meet the requirements of the creditors., which is just the flow of assets divided by current liabilities....   [tags: Finance, Investment, Asset, Debt]

Better Essays
735 words (2.1 pages)

Using Reliable Access Of External Finance For Smes Essay

- 2. Available sources of finance for SMEs Creating reliable access of external finance for SMEs is an issue that policy makers around the globe pay attention to () . There are three available sources of finance for SMEs. 2.1 Informal finance The two main informal finance sources are 3F (founder, family and friends) money and business angels (Colin M Mason, 2005:5) and they are the starting point for nearly all newly established enterprises. Nearly 90% of all new enterprises are founded only with 3F money () ....   [tags: Bank, Debt, Investment, Economics]

Better Essays
920 words (2.6 pages)

Essay on Firm Financing And Debt Financing

- QUESTION 1: Firm financing is a very important aspect for the operations of any company and this is done prior to any business strategies are made. Most company commonly pursues to use equity financing and debt financing. In debt financing funds borrowed must be repaid with interest whereas equity financing funds is acquired by sale of shareholders interest of the company. Some banks may require the firm to maintain a balance between debt and equity which is suitable in the industry and the state of the business is working (Melicher, Welshans, and Wel.., 2011)....   [tags: Generally Accepted Accounting Principles, Asset]

Better Essays
956 words (2.7 pages)

Essay about Comparing Better Brew and Perfect Blend Coffee Comapnies

- Comparing Better Brew and Perfect Blend Coffee Comapnies After years of dreaming about owning you own business, you decided that owning a coffee shop would be perfect. Rather than start from scratch, however, you and your partners decide to look at two existing establishments, Better Brew and Perfect Blend. The two are for sale at the same price, and they are located in equally attractive areas. You manage to get enough financial data to compare the year-end condition of the two companies. What factors should you consider before deciding which company to buy....   [tags: Business Analysis Compare Contrast]

Free Essays
1642 words (4.7 pages)

Debt Financing Essay examples

- The financial plan of any company is important. One of the most important factors or decisions is the plan to use debt financing, equity financing, or a combination of the two. The decision to go with one or the other is large and mostly relies on personal feelings about the topic. Some owners want full control and therefore lean to debt financing and others lean to equity financing with the ability to give up some control of the company. For the hard charging entrepreneur, the most control is best....   [tags: Business Finance]

Free Essays
1080 words (3.1 pages)