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What makes Company risky, Debt or equity? and Why?

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Question added by Khalid Noor , Accounting Manager , FedEx
Date Posted: 2013/11/03
Rehan Qureshi
by Rehan Qureshi , Financial Consultant , Self Employeed

Risk of Both Debt & Equity Capital to Companies:

Debt and equity are two forms of financing a company can use to fund its business. Lenders, such as bondholders or banks, supply debt capital, which must be must repaid. Investors supply equity capital, which entitles them to shares of stock and partial ownership in the company. A company does not need to repay equity capital. Both types of capital present certain risks to a small business.

Debt Repayment Risk

Debt capital requires a business to make periodic payments to a lender. These payments might include interest, principal or both. If a company is unable to make these payments, it risks losing assets it pledged as collateral and might be forced into bankruptcy. For example, if you put up business equipment as collateral for a small-business loan and miss your monthly payments, the lender might take the equipment to satisfy the loan or you might be forced to file bankruptcy.

Risk of Being Underfunded

Too much debt might restrict a company’s ability to raise additional capital, which can prevent a company from getting the cash it needs if it gets into a bind. An existing lender might restrict a business from taking on more debt. Or, potential new lenders and investors might refrain from providing capital to an over-leveraged company. For example, if your small business has too much existing debt, new investors and lenders might deny your request for more money, which might limit your ability to operate.

Loss of Ownership

If a business raises too much equity capital, it risks losing control of the company. Equity investors are typically entitled to vote on certain company matters. If you sell a large equity stake to one investor or a group of investors, they might try to influence the company in a way with which you don’t agree. For example, if your small business sells a60 percent stake in the company to an investor, he might try to take over the company if he is unsatisfied with your performance.

Missing Growth Opportunities

 

Depending on the agreement between a business and its investors, the business might be required to periodically distribute a portion of its profits to shareholders in the form of dividends. A small business in a growth phase typically wants to reinvest all of its profits into its business. If a company distributes too much of its profits to investors, it risks missing out on growth opportunities. For example, if your small business generates $50,000 in quarterly profit, but distributes $40,000 to investors, your growth potential might be limited.

The value of the debt instrument (bond) is based upon the company's / government's ability to repay the debt/ loan. The value of a share of stock (equity) is based upon expected future earnings.

Debt is riskier than equity because the lender might suddenly demand their money back.

Saad Kapadia FCA - CIA - CFE - CISA - CRMA-FMVA
by Saad Kapadia FCA - CIA - CFE - CISA - CRMA-FMVA , Head Of Internal Audit , Cenomi Centers - Joint Stock Company

Debt, since Company is required to pay committed amout of interest irrespective of profitablity of Company.

Debt or Equity, depends on where exactly is the company, its prospects, its stage in growth cycle and other factors. While Debt definitely adds commitment of payback, equity permanenently forgoes any gains of that portion of profits.

 

To put it simply, in a fast growing companies with strong visibility, Equity (issuance) is a definite risk. And in a old world industry with lots of competitors, of saturated customers, technology or markets; or low entry barriers etc, Debt is definitely a risk.

 

Distilled further, if you have good revenue and profit visibility then Equity is the risk, if revenue and profit visibility is low or bad, then debt is definite risk.

Mohammad Al-Shayeb
by Mohammad Al-Shayeb , Finance Manager , Syriatel

Debt is risky more than equity since it has fixed cost (interest) which sould be paid to the debt holder regardless of the company's financial results.

However, debt also has its positive impact since interest is tax deductible, so it can raises the profits of the company.

Both debt and equity are forms of financing a company. Debt is repayable and further needs regular payment of financial charges. Higher the size of debt, higher the risk the company may fail to make such payments. The failuire to pay the debt may even force a company to wind up or curtail its operations. On the other hand, cheap debts help companies to post more profits. 

Although debt helps companies to increaes its profits, but even then it adds more risk to overall risk exposure of the company. 

 

Debt is more riskier than equity because, if you raise debt, money must paid back within a fixed amount of time. If you carry too much debt you will be seen as "high risk" by potential investors – which will limit your ability to raise capital by equity financing in the future. Debt financing can leave the business vulnerable during hard times when sales take a dip. Debt can make it difficult for a business to grow because of the high cost of repaying the loan. Assets of the business can be held as collateral to the lender. And the owner of the company is often required to personally guarantee repayment of the loan.

mukkur srinivasan varadhan
by mukkur srinivasan varadhan , Chartered Accountant , Chartered Accountant in practice

(1)Even in the face of loss, interest on debt is required to be paid..

(2)Debt capital is sought based on the cost -benefit analysis in the company.i.e If the ROI in the company is a percentage ,debt is raised for a % less than the ROI.As business is dependent on market conditions ,possibility is there, ROI may fall below the interest on debt.

(3)Debt has to be rapaid on maturity or after a fixed term, liquidity has to be maintained at that time.

(4)For raising debt,securities have to be submitted.So alongwith debt ,the securities also become at stake , when the market conditions are not good.

(5)Unless statutory compulsion is there, dividend declaration can be postponed.In that case ,cost of such internal financing is much less.

(6)In case of liquidation, debt becomes a preferential payment,esp. when secured.Equity takes last preference.

So debt is riskier.

 

suleman anjum
by suleman anjum , Accounts and Finance Executive , Paksolarcells Pvt. ltd

Debt and equity are two forms of financing a company can use to fund its business. Lenders, such as bondholders or banks, supply debt capital, which must be must repaid. Investors supply equity capital, which entitles them to shares of stock and partial ownership in the company. A company does not need to repay equity capital. Both types of capital present certain risks to a small business.these risk may involve in this criteria

  • Debt Repayment Risk
  • Risk of Being Underfunded
  • Loss of Ownership
  • Missing Growth Opportunities

Amjad Ali
by Amjad Ali , Regional Manager , NATIONAL BANK OF PAKISTAN

Debt because it is to be serviced irrespective of profitability and appropriate cashflows otherwise it will be default if not paid as per agreed terms

Ezzidin Ibrahim
by Ezzidin Ibrahim , Financial Controller , Karim Food Industries

The company will be at higher risk when total debits exceed equity, which means that majority of the operating profit will be used to pay for the interest on debts. 

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