Merits and demerits of equity financing
Equity Financing means the owner, equity and financing. Generally, small-scale businesses, such as partnerships and sole proprietorships, are operated by their owners through their own finances. Public limited companies operate on the basis of capital shares, but their management is different from that of shareholders and investors.
Merits of equity financing:
The following are the merits of equity financing:
(i) Permanent in nature: Equity financing is permanent in nature. No refund required unless settlement occurs. The shares, once sold, remain on the market. If any shareholder wants to sell these shares, they can do so on the stock exchange where the company is listed. However, this will not pose any liquidity problem for the company.
(ii) Solvency: Equity financing increases the solvency of the business. It also helps to improve the financial situation. In times of need, share capital can be increased by inviting the general public to subscribe for new shares. This will allow the company to successfully cope with the financial crisis.
(iii) Credit capacity: High equity financing increases credit worthiness. A company in which equity financing has a high proportion can easily apply for bank loans. Unlike companies that are heavily burdened with debt, they no longer remain attractive to investors. A higher proportion of equity financing means that less money will be needed to pay interest on loans and financial expenses, so much of the profits will be distributed to shareholders.
(iv) Without interest: No interest is paid to any third party in the case of equity financing. This increases the net income of the business that can be used to expand the scale of operations.
(v) Motivation: As with equity financing, all profits remain with the owner, thus giving them motivation to work harder. The feeling of inspiration and care is greatest in a business that is financed with the owner’s money. This keeps the entrepreneur conscious and active in seeking opportunities and making a profit.
(vi) Without danger of insolvency: Since there is no capital borrowed, no repayment is required on a strict schedule. This frees the entrepreneur from financial worries and there is no danger of insolvency.
(vii) Settlement: In the event of dissolution or liquidation, there is no third party charge on the assets of the company. All assets remain with the owner.
(viii) Capital increase: Public limited companies can increase both the issued and authorized capital after meeting certain legal requirements. Therefore, in times of need, financing can be obtained by selling additional shares.
(ix) Advantages of the macro level: Stock financing produces many benefits at the social and macro level. First, it reduces the elements of interest in the economy. This makes people panic and financially worried. Second, the growth of public limited companies allows large numbers of people to share their profits without actively participating in their management. Therefore, people can use their savings to earn monetary rewards for a long time.
Demerits of equity financing:
The following are the demerits of equity financing:
(i) Decrease in Working Capital: If the majority of company funds are invested in fixed assets, companies may experience a shortage of working capital. This problem is common in small-scale businesses. The owner has a fixed amount of capital to start with and most of it is consumed by fixed assets. Therefore, there is less left to cover current business expenses. In large-scale companies, financial mismanagement can also lead to similar problems.
(ii) Difficulties in making regular payments: In the case of equity financing, the entrepreneur may have problems making regular and recurring payments. Sales revenue can sometimes drop due to seasonal factors. If insufficient funds are available, there will be difficulties in meeting short-term liabilities.
(iii) Higher taxes: Since no interest must be paid to any third party, the company’s taxable income is higher. This results in a higher incidence of taxes. In addition, there is double taxation in certain cases. In the case of a corporation, all income is taxed before any allocation. When dividends are paid, they are taxed again on the recipients’ income.
(iv) Limited expansion: Due to equity financing, the entrepreneur cannot increase the scale of operations. Business expansion requires large financing to establish a new plant and capture more markets. Small-scale companies also do not have professional guidance to expand their market. There is a general tendency for owners to try to keep their business at a limit in order to maintain affective control over it. As the business is financed by the owner himself, he is very obsessed with the possibilities of fraud and embezzlement. These factors make it difficult for the business to expand.
(v) Lack of research and development: In a company that is run solely on equity finance, there is a lack of research and development. Research activities take a long time and a large amount of funding is needed to come up with a new product or design. These research activities are undoubtedly expensive, but eventually, when their results are released to the market, huge revenues are obtained. But the problem arises that if the owner uses his own capital to finance long-term research projects, he will have trouble meeting short-term obligations. This factor discourages investment in research projects in a company financed with its own resources.
(vi) Delay in replacement: Companies that work with capital financing, face problems when modernizing or replacing capital equipment when it wears out. The owner tries to use the current equipment as long as possible. Sometimes you can even ignore the deterioration in production quality and still use old equipment.