Shareholder Equity or Debt – How Much These Impact Business Value?

business valuation

Every growing company needs capital to keep its operations going. When companies start to scale, they need more investment to hire more employees, get advanced machinery, scale the production, add new products, and more. In short, they need more investment to expand the business operations to improve the business valuation.

No doubt, there are numerous ways to expand business operations. But, the most common way to get an investment is in the form of the owner’s capital investment or debt. Each way supports your business’s financial standing, but each investment type entails a recurrent effect on your business.

What exactly are shareholder equity and debt, and what do they encompass? Well, if these questions are bothering you, we will take you down the definitive guide on what these terms mean and how they impact business value.

What is Shareholder Equity?

Shareholder equity is the shareholders’ claim on retained assets after all debts owed are paid off. It basically refers to the profit of the owner and determines the return generated by a business compared to the total amount invested in the company. In the event of a company’s liquidation, the amount of money returned to the owner after satisfying all debts and expenses is called shareholder equity.

This metric allows investors and analysts to define the value of financial ratios related to the company, providing them the insight and tools to make better and well-informed future investment decisions. Conceptually, stockholders’ equity is a tool for judging the funds retained within a business and how well the company performed.

The formula to calculate the Shareholder Equity is -

Share Holder Equity = Total Assets - Total Liabilities

How Does Shareholder Equity Impact Business Value?

If the shareholder equity figure is negative, it is an indication that the business is running at a loss and may encounter an upcoming bankruptcy – especially if there are exceedingly large liabilities.

On the other hand, a positive Shareholder Equity value means that the company has enough assets to cover its liabilities, and the company will still retain capital. The surplus of shareholder equity shows the firm’s ability to sustain and grow profits over time.

Moreover, when a company’s stockholders invest their shareholder’s equity to sail the growth of the company, they gain a few advantages and disadvantages for the company that include –

Advantages

  1. Increase in in-house knowledge and trust of the employees in the company. 
  2. It reduces wasted time since no shares have to be sold and no details of the other individuals need to be collected, thus increasing the business valuation. 
  3. Avoid contact with varied investment sources – which saves the company from any likely fraud and debts. 
  4. Saves a lot of time as the company does not have to invest time on extra paperwork or legal documents. 
  5. By finding the shareholder’s equity, we can effortlessly summarize the assets and liabilities of the company and determine its performance.

Disadvantages

  1. Regulating the retained earnings in the business and not taking debts limit the company’s ability to invest in resources for expansion. 
  2. You will not have free cash flow in the business.
  3. The expansion of the business is slower.

What is Debt?

Debt is an amount of money borrowed from a bank or private lender. The lender offers the money to the borrower upon taking the agreement from the borrower to pay the money back with interest – where the borrower pays the interest at regular intervals. The debt can be in any form, including debentures, loans, borrowing, etc. Typically a borrower lends a loan in exchange for the mortgage of any hard asset. The asset is returned to the borrower as soon as the borrowed amount and the interest are paid back completely.

How Does Debt Impact The Business Value?

Debt financing has in practice, a far lower payoff than many other financing options. Moreover, it has been the conventional wisdom that the aggressive yet in-limit upright use of the financial leverage pays off in higher company value. That is because debt is finite. You contractually pay the interest in intervals and pay off the entire principal amount in a fixed time period. After the debt is paid, you are no longer liable to pay any amount to anyone. Whereas, if you go for other financing options like, equity shares, you will pay a part of your income to your equity holders forever. So, debt will help you build the capital structure, buy machinery and other resources all while entailing an increased business valuation.

Additionally, when a company borrows from a lender, it has a few advantages and disadvantages, which are as follows:

Advantages

  1. A company can easily get the loan from the lender if they are eligible and forecast how they will pay it back over a specific period of time. 
  2. The debt increases the cash flow, which enables companies to perceive their operations and growth initiatives smoothly. 
  3. Debts save the company from avoidable taxes and charges, which leads to a heavy burden on a company. 
  4. Debt keeps the ownership of the company with you, unlike equity. 
  5. Debt improves the company’s credit score if the company pays the interest and the principal amount at the right time.

Disadvantages

  1. Excess debt can lead to financial distress and bankruptcy 
  2. If you fail to pay the amount due, creditors can pursue payment of interest or repayment of the principal amount. 
  3. By agreeing to provide the collateral to the lender, you risk your business assets.

Wrapping Up

While debt and shareholder equity are both investments for the business, there are differences between them, and their effects are different. Shareholder equity prevents the company from taking any debt or liability but provides the capital to sail the business. Whereas debt is the most inexpensive financing option a company has that fuels the growth and does not affect the business valuation if the installments and interest are paid on time.

Need help with your financing options? Talk to our experts today!