Starting or growing a business in India often needs money. This money can come from different sources, but mostly, entrepreneurs choose between debt and equity financing. If you are a business owner or planning to start one, understanding the difference between debt vs equity funding is very important. It helps you make the right choice and grow your business smoothly without unnecessary risks.
In this blog, we will explain debt vs equity, their pros and cons, and how you can decide which is the best for your business. We will also discuss important terms like debt to equity ratio, loan to equity ratio, and how to calculate debt to equity ratio for your company.
What is Debt Funding?
Debt funding means borrowing money from banks, financial institutions, or investors. It is like taking a loan, which you must repay with interest over time.
For example, if you take a loan of ₹10 lakhs from a bank at 10% interest, you will have to pay back the ₹10 lakhs plus interest as per the agreed schedule. The bank doesn’t own any part of your business. You remain the sole owner.
Pros of Debt Financing
- Ownership stays with you: You don’t have to share your business profits or decisions.
- Tax benefits: Interest paid on debt is usually tax-deductible.
- Fixed repayment: You know exactly how much to pay back and when.
- Quick access: Debt can often be faster to arrange than equity.
Cons of Debt Financing
- Repayment pressure: You must pay back even if the business is not making profit.
- Risk of default: Missing payments can harm your credit score or lead to legal issues.
- Collateral needed: Often, lenders require collateral or security.
What is Equity Funding?
Equity funding means raising money by selling shares of your company to investors. These investors become part-owners of your business.
For example, if you raise ₹10 lakhs by selling 10% shares of your company, the investors own 10% of your business. They get a share of profits, and sometimes a say in business decisions.
Pros of Equity Financing
- No repayment pressure: You don’t have to repay the money; investors earn through dividends or share value increase.
- Shared risk: Investors share the business risks with you.
- Access to expertise: Investors often bring experience, connections, and advice.
- Better cash flow: No fixed monthly repayments help improve cash flow.
Cons of Equity Financing
- Loss of control: You may lose some decision-making power depending on the share sold.
- Profit sharing: Future profits are shared with investors.
- Dilution: Your ownership percentage decreases.
- Costlier: Raising equity can be more expensive and time-consuming than debt.
Debt vs Equity Funding Key Differences
| Aspect | Debt Financing | Equity Financing |
| Ownership | No change; lender is not an owner | Investors get part ownership |
| Repayment | Fixed repayments with interest | No repayment; profit sharing |
| Risk | Borrower bears full risk | Risk shared with investors |
| Tax Benefits | Interest is tax-deductible | Dividends are not tax-deductible |
| Control | Full control retained by owner | Control may dilute depending on shares sold |
| Cost | Interest and fees | Giving up equity can be costly |
Read More: Debt Financing Explained: Guide to Business Growth
What is Debt to Equity Ratio?
Once you start your business, you might want to understand how much money comes from debt and how much comes from equity. This is where the debt to equity ratio becomes useful.
The debt to equity ratio is a financial measure that compares your company’s debt with its equity. It helps investors, lenders, and business owners understand the financial risk and stability of the business.
Debt to Equity Ratio Formula
You can calculate the debt to equity ratio using this simple formula:
Debt to Equity Ratio = Total Debt / Total Equity
Where:
- Total Debt = All the money your business owes (loans, bonds, other liabilities)
- Total Equity = The money invested by owners and shareholders
Why is Debt to Equity Ratio Important?
- Shows financial use: A high ratio means you rely more on borrowed money.
- Indicates risk: More debt means higher risk in tough times.
- Helps in decision making: Lenders use this ratio to decide if they should give you a loan.
How to Calculate Debt to Equity Ratio? (Example)
Suppose your business has total debt of ₹50 lakhs and total equity of ₹1 crore.
Using the formula:
Debt to Equity Ratio = 50,00,000 / 1,00,00,000 = 0.5
This means your business has ₹0.50 of debt for every ₹1 of equity, which is generally considered a safe balance.
Debt and Equity Ratio in Indian Business Context
In India, the ideal debt and equity ratio varies by industry. For example:
- Manufacturing companies usually have a debt to equity ratio between 1 to 2.
- Service companies prefer a lower ratio, around 0.5 to 1, because they have less need for heavy assets.
- Startups often have higher equity and less debt initially, as banks may hesitate to lend.
The Indian government and banks encourage startups and MSMEs (Micro, Small, and Medium Enterprises) to maintain a balanced loan to equity ratio to avoid overburdening with debt.
When Should You Choose Debt Financing?
Debt financing is a good option if:
- Your business has a steady cash flow to repay loans.
- You want to retain full ownership and control.
- You want tax benefits from interest payments.
- You have collateral to secure the loan.
- You need quick funding for short-term needs.
For example, many businesses use bank loans or business lines of credit to buy inventory or machinery.
When Should You Choose Equity Financing?
Equity financing is best if:
- Your business is new or risky, so banks hesitate to lend.
- You want to share risks with investors.
- You want expertise and mentorship from investors.
- Your business requires a large amount of capital.
- You cannot or do not want to provide collateral.
Many startups in India raise funds through angel investors or venture capital to scale rapidly.
Debt and Equity Financing: Can You Use Both?
Absolutely! Most businesses use a mix of debt and equity financing to balance risk and growth.
For example, a company might use equity funding to build infrastructure and debt to manage working capital. This mix helps optimize the debt equity ratio and keep the business financially healthy.
Tips to Decide Between Debt vs Equity Funding
- Assess your business stage: Startups often rely on equity, while mature businesses use debt.
- Evaluate cash flow: If steady cash flow is there, debt can be manageable.
- Consider control: If you want to keep full control, debt is better.
- Think about risk: If you can handle risk, debt is fine; if not, equity shares risk.
- Look at costs: Compare the cost of interest vs. giving up profits.
- Check loan to equity ratio: Maintain a healthy balance to avoid financial troubles.
Conclusion: Debt vs Equity: What’s Right for Your Business?
Choosing between debt and equity funding is not simple. Both have pros and cons, and the right choice depends on your business needs, growth plans, risk tolerance, and financial health.
Understanding terms like debt to equity ratio, loan to equity ratio, and how to calculate debt to equity ratio helps you make informed decisions. Remember, sometimes a good combination of both is the best path to success.
If you are still unsure, consult with a financial advisor or expert who can guide you based on your specific business situation. For better assistance you connect with BigMudra customer care team at anytime, we are available 24×7.
