Every asset on a balance sheet was paid for by someone. Look at the right side of the equation, : the money came either from creditors (liabilities) or from owners (shareholders' equity). When a growing company needs $2 million for a new warehouse, its managers face a real choice. They can borrow the money and promise to pay it back with interest, or they can sell part of the company to new owners who will never be repaid but will share in every future dollar of profit. Neither choice is free. This lesson compares the two so you can explain why a company picks one, the other, or a mix, and so you can see how borrowing can make shareholders richer in a good year and poorer in a bad one.
Debt financing: borrowing the money
Debt financing means borrowing. The business receives cash now and records a liability; later it pays back the principal plus interest. Common forms are a bank term loan (a fixed amount repaid over several years), a line of credit (borrow up to a limit as needed, usually for short-term needs), a note payable (a written promise to pay a specific amount on a specific date, with interest), a mortgage (a loan secured by land or buildings) and, for larger corporations, bonds. Three features define debt. First, it must be repaid on schedule whether the business is profitable or not; missing a payment can let the lender seize pledged assets or force the business into bankruptcy. Second, interest is generally a tax-deductible business expense, so the government effectively pays part of it. Third, lenders do not become owners: they get no vote and no share of extra profit.
| Bond term | Meaning | Example |
|---|---|---|
| Face value (par value) | The amount the issuer must repay at maturity; interest is calculated on it. | $500,000 |
| Contract rate (coupon or stated rate) | The annual interest rate printed on the bond. | 6% per year |
| Interest dates | When interest is paid. Canadian corporate bonds usually pay semi-annually (every 6 months). | June 30 and December 31 |
| Term and maturity date | How long until the face value is repaid, and the day it is due. | 10 years; matures January 1, 2036 |
| Bondholder | The investor who lends the money by buying the bond. A creditor, not an owner. | A pension fund buys $100,000 of the issue |
Suppose Birch Lake Corp. issues $500,000 of 10-year, 6% bonds at face value on January 1, 2026, with interest paid every June 30 and December 31. Each interest payment covers half a year: The bonds are a long-term liability until the final year, when they become a current liability because they are due within 12 months.
| Date | Account | Debit | Credit |
|---|---|---|---|
| 2026 Jan 1 | Cash | $500,000 | |
| Bonds Payable | $500,000 | ||
| Issued 10-year, 6% bonds at face value | |||
| 2026 Jun 30 | Bond Interest Expense | $15,000 | |
| Cash | $15,000 | ||
| Semi-annual interest: $500,000 x 6% x 6/12 | |||
| 2026 Dec 31 | Bond Interest Expense | $15,000 | |
| Cash | $15,000 | ||
| Semi-annual interest | |||
| 2036 Jan 1 | Bonds Payable | $500,000 | |
| Cash | $500,000 | ||
| Repaid bonds at maturity |
Equity financing: selling ownership
Equity financing means selling shares. A corporation issues common shares (owners who vote for the board of directors and receive dividends only if the board declares them) or preferred shares (usually no vote, but a fixed dividend that must be paid before common shareholders get anything, and priority over common shares if the company is wound up). Shares issued by most Canadian corporations have no par value, so the full amount received is credited to the share account: issuing 50,000 common shares at $10 is recorded as a $500,000 debit to Cash and a $500,000 credit to Common Shares. Equity is never repaid, and dividends are optional, which makes equity the safer source for the company. The cost is ownership. New shareholders share all future profits, dividends are paid from after-tax income (they are not deductible), and existing owners suffer dilution: their percentage of the company, and of the votes, shrinks.
- Advantage: owners keep full control and all of the extra profit
- Advantage: interest is generally tax-deductible, lowering the real cost
- Advantage: the cost is known and fixed in advance
- Disadvantage: principal and interest are due even in a bad year
- Disadvantage: lenders may demand collateral and impose conditions (covenants)
- Disadvantage: more debt raises the risk of insolvency and the cost of future borrowing
- Advantage: never has to be repaid
- Advantage: dividends are optional, so cash is not drained in a bad year
- Advantage: strengthens the balance sheet, making future borrowing easier
- Disadvantage: dilutes existing owners' control and share of profit
- Disadvantage: dividends are paid from after-tax profit (not deductible)
- Disadvantage: issuing shares publicly is costly and brings disclosure rules
Financial leverage: how debt magnifies returns
Financial leverage means using borrowed money to increase the return to shareholders. It works whenever the business earns a higher rate on its assets than it pays in interest: the surplus belongs to the shareholders, who put up less of their own money. It works against them when the business earns less than the interest rate. Consider a company that needs $1,000,000 of assets and pays tax at 25%. Plan A raises all $1,000,000 from shareholders. Plan B raises $500,000 from shareholders and borrows $500,000 at 6%, so interest is a year. Return on equity (ROE) is net income divided by shareholders' equity.
| Plan A good year | Plan B good year | Plan A bad year | Plan B bad year | |
|---|---|---|---|---|
| Income before interest and tax | $150,000 | $150,000 | $40,000 | $40,000 |
| Interest expense | $0 | $30,000 | $0 | $30,000 |
| Income before tax | $150,000 | $120,000 | $40,000 | $10,000 |
| Income tax (25%) | $37,500 | $30,000 | $10,000 | $2,500 |
| Net income | $112,500 | $90,000 | $30,000 | $7,500 |
| Shareholders' equity | $1,000,000 | $500,000 | $1,000,000 | $500,000 |
| Return on equity | 11.25% | 18.0% | 3.0% | 1.5% |
Alternative sources of funding
A brand-new or small business often cannot sell shares to the public or borrow easily from a bank, because it has no track record and few assets to pledge. It turns to other sources, each of which is still a form of debt, equity, or a grant that is neither.
| Source | How it works | Debt, equity or neither? |
|---|---|---|
| Angel investors | Wealthy individuals invest their own money in an early-stage business, often adding advice and contacts. | Equity (sometimes a convertible loan) |
| Venture capital | Firms invest pooled funds in high-growth businesses in exchange for a significant ownership stake and often a board seat; they expect to sell the stake later at a large gain. | Equity |
| Business Development Bank of Canada (BDC) | A federal Crown corporation that lends to and invests in Canadian entrepreneurs, often taking on more risk than a commercial bank. | Mostly debt; some equity |
| Government loan programs and grants | Federal and provincial programs offer loans, loan guarantees (for example, the Canada Small Business Financing Program guarantees part of certain loans made by private lenders) and grants for research, hiring or exporting. | Loans are debt; grants are neither and need not be repaid if conditions are met |
| Crowdfunding | Many people each contribute a small amount online. Reward-based crowdfunding gives backers a product or perk; equity crowdfunding sells small ownership stakes and is regulated by securities regulators. | Rewards: neither (pre-sales); equity crowdfunding: equity |
| Leasing | The business pays to use an asset (vehicles, equipment, space) instead of buying it, conserving cash. Under IFRS most leases appear on the lessee's balance sheet as an asset and a lease liability. | Debt-like obligation |
| Retained earnings | Profit kept in the business instead of paid as dividends. The cheapest source, but limited by how profitable the business is. | Equity (internal) |