Accounting – 5.3 Limited companies | e-Consult

Debt Financing: This involves borrowing money from external sources, such as banks or issuing bonds. The company is legally obligated to repay the principal amount plus interest. Debt financing increases a company's financial risk because it creates fixed repayment obligations, regardless of the company's profitability. However, interest payments are often tax-deductible, which can reduce the effective cost of debt.

Equity Financing: This involves raising capital by selling shares in the company. The company does not have a legal obligation to repay the capital invested by shareholders. Equity financing does not increase a company's financial risk in the same way as debt financing. However, equity financing can dilute the ownership of existing shareholders. The return to equity investors is variable and depends on the company's profitability.

Impact of Capital Structure on Financial Risk and Profitability:

• A company with a high proportion of debt in its capital structure will have higher financial risk. This is because it has fixed repayment obligations that must be met, even if the company is not profitable.
• A company with a high proportion of equity in its capital structure will have lower financial risk. This is because it does not have fixed repayment obligations.
• Preference shares act as a hybrid between debt and equity. They have features of both. They are like debt because they have a fixed dividend payment, but they are like equity because they do not have a legal obligation to repay the capital invested. Including preference shares in the capital structure can reduce the amount of debt a company needs to borrow, thereby lowering its financial risk. However, the fixed dividend payment on preference shares is a burden on the company's cash flow.