You’re going to hear the term “leverage” a lot in the world of finance, and although it is a word that might seem convoluting on the surface, when understood, it is actually quite simple.
When a company leverages an investment, they will generally apply leveraging techniques by borrowing money (debt) rather than raising equity. The big debate between debt vs equity financing is one that is constantly considered in today’s day in age. Can we use both debt and equity to finance investment activities? Is there an optimal combination of both? Let’s use visual learning techniques to first better understand the meaning of capital structures and the differences between debt vs equity financing.
Generally, a company’s capital structure is referred to as its combination of debt and equity that is used to finance its ability to grow as well as its overall operations. Debt will typically be used in in the form of the issuance of bonds or long-term notes payable, whereas equity can be used by the issuance of common stock, preferred stock or retained earnings.
Debt financing is the term used when a company borrows money to invest in its operations and growth. Debt financing can occur when a firm raises money for working capital or for capital expenditures by selling debt instruments to either institutional investors or to individuals. Debt financing can come in various forms:
Short-term Debt Financing:
Short-term debt, also referred to as short-term current liabilities is a form of obligation that will generally be paid back in the near future (12-months or less). Short-term debt financing is a form of debt financing that will assist in a company in funding something that needs immediate support (e.g. a company purchases a piece of equipment for $15,000 on short-term credit, to be paid within 30 days, the $15,000 is categorized as short-term debt). Other forms of short-term debt consist of, but are not limited to the following:
Commercial paper – Commercial paper is a short-term debt instrument issued by a company that is generally unsecured. Commercial paper will typically be used for financing short-term liabilities, or the financing of accounts receivables or inventories.
Short-term notes payable – Short-term notes payable are obligations that will need to meet a specific sum amount plus accrued interest within 12 months. These can also be applicable to the payment of short-term accounts payable that have been converted into short-term notes payable.
Extended short-term lines of credit – An arrangement between a customer and a financial institution that will establish the maximum amount of loan that the customer can borrow. An extension is the ability for the customer to pay off the loan at a later date.
Debenture – A debenture is an unsecured obligation used by a company to an investor. If a default on the loan occurs, the holder of the debenture bond will have the status of the general creditor.
Subordinated debentures – A subordinate debenture is a bond that is considered unsecured and will be behind all senior creditors in the event of company liquidation.
Junk bonds – A junk bond is a high-yield fixed income instrument that come with a high default risk in relation to investment grade bonds. Leveraged buyouts are typically used from junk bonds.
Income bonds – Income bonds are securities that pay interest merely on the achievement of specified income levels. Income bonds will generally only be used in reorganizations.
Long-term Debt Financing:
Similar to short-term debt financing, long-term debt financing is a form of financing a business’s operation by using moneys obtain in a borrowing arrangement that will be paid back in a period that is in excess of 12 months. Long-term debt financing includes, but is not limited to:
Long-term notes payable – Long-term notes payables are obligations that will be paid back in a period of over 12 months. These will appear in the company’s long-term liabilities section of their balance sheet.
Debentures – Debentures are unsecured loan certificates that are issued by an organization and will generally be backed by general credit rather than company assets.
Bonds – Bonds are debt instruments of indebtedness and are typically traded on open market exchanges.
Capital leases – Lease obligations that will generally transfer ownership from the lessee to the lessor at the end of the lease agreement.
The primary concept of equity financing is that its methodology for raising capital is by selling company stock to various investors. In return for the shareholders’ investment, the shareholders will receive ownership in the company. There are various forms of stock ownership:
Common Stock- Common stock offers shares that entitle shareholders to dividends that vary in amount and may even be missed, depending on the income of the company each year.
Preferred stock – Preferred stock is a class of ownership in a corporation that has a higher claim on its assets and earnings than common stock will. Examples and features include:
- Cumulative dividends – Cumulative dividends on preferred stock are dividends that are in arrears from the prior period and will be paid prior to the distribution of common stock dividends.
- Participating stock features – Preferred shares that are able to participate in declared dividends with the common shareholders to the extent that dividend amounts undistributed will exist after satisfying both preferred dividend requirements and common shareholder requirements at the preferred dividend rate.
- Voting rights in the stock – Stock shareholders will be able to vote on certain issues including board of director members, corporate objectives, and stock splits.
The combination of debt and equity when financing investments can be optimized by applying more complex calculations (e.g., weighted average cost of capital), but if you’re struggling to understand the meaning of capital structures, starting with the basics is key. Always remember, in order to move fast, we must sometimes first move slow.