I understand the difference between the two. But I’m confused as to when would either be necessary especially in the context of pessimistic and optimistic sales forecast. Thank you in advance!
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Equity is where the company sells pieces of itself (stocks, etc) in exchange for money. That money isn’t a debt that the company must repay. The investors are paid as the value of the stock increases. Debt financing is exactly that, the company borrows the money and agrees to pay it back according to a specific schedule.
It is not the company which decides what kind of financing they are going to get. The company have to follow the budget that is approved by the owners. And equity financing needs direct approval from the owners. With equity financing the owners will dilute their own ownership of the company. So the owners tend to prefer that the company does debt financing. However for debt financing you need a lot more security. You might get investors to part way with their cash using optimistic sales forecasts, they gamble, a bank need more reliable numbers, even the pessimistic sales forecasts may yield high interest rates and you need actual signed contracts to get the rates you can pay.
Although sales forecasts are one aspect of the situation, for financing (debt or equity) the relevant question is what is the purpose of the additional funding.
If the funding is to increase the working capital to account for increased operations, broadly speaking, most companies would prefer debt. The increase in operations would presumably result in increased cash flow and profitability. This is a relatively easy sell to banks for loans. And there is a range of credit facilities – line of credits, short term loans etc.
If the funding is for long term investment, then the matter is more complicated. The choice of funding will be related to the riskiness of the investment, expected returns and time needed. If a company does this from a position of strength (ie history of profitability, sales increasing and need a new factory or capital for expansion), then debt is likely preferred if it can be obtained at a reasonable interest rate.
If the company is in a position of weakness (ie wants to embark on a very different line of business, recent loss of profitability, poor cash flow projections), it is more likely that banks will require fairly high interest rates or give poor terms. The company might have little choice but to pursue equity financing.
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