Advantages and Disadvantages of Debt Compared to Equity

OK… here is a quick list of advantages and disadvantages of debt vs equity.

Understanding the critical differences between debt and equity is important for any investor. Too many beginning investors grasp these concepts too late.

Advantages of Debt Compared to Equity

  • Debt does not dilute the owner’s ownership interest in the company. Lenders do not become owners
  • The lender is only entitled the agreed-upon principal of the loan plus interest, and has no claim on profits of the business
  • With fixed loan rates, the company can forecast monetary obligations
  • Interest on the debt can be deducted on a company’s tax return
  • A company is not required to comply with state and federal securities laws and regulations when applying for a debt loan

Disadvantages of Debt Compared to Equity

  • Unlike equity, debt must at some point be repaid
  • Interest is a fixed cost which raises the company’s break-even point. Companies that are too highly leveraged (large amounts of debt compared to their equity) find it difficult to grow because they are paying off debt
  • Cash flow is required for both principal and interest payments and must be budgeted for over time
  • The larger a company’s debt-equity ratio, the riskier the company is considered by lenders and investors (a business is limited as to the amount of debt it can carry)
  • The company often has to pledge its assets to the lender as collateral

 

Here is a good video on describing the difference between Debt and Equity.

The presenter has an Indian accent but knows what he’s talking about.

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