What is the difference between equity financing and debt financing?

Definition of Equity Financing

Equity financing involves increasing the owner's equity of a sole proprietorship or increasing the stockholders' equity of a corporation to acquire an asset.

When a corporation issues additional shares of common stock the number of issued and outstanding shares will increase. This increase will cause the previous stockholders' ownership percentage to be reduced.

Definition of Debt Financing

Debt financing means borrowing money in order to acquire an asset. Financing with debt is referred to as financial leverage. Using debt financing allows the existing stockholders to maintain their percentage of ownership, since no new stock is being issued. However, the additional debt adds risk and may result in higher interest rates for future loans.

Debt financing often comes with strict conditions or covenants regarding interest and principal payments, maintaining certain financial ratios, and more. Failure to meet those conditions can result in severe consequences. In the U.S., a benefit of debt financing is that the interest on the debt is an income tax deductible expense. This income tax savings will partially offset the interest expense on the debt.