Whether for business operations, growth and expansion, or acquisitions, selecting optimal financing sources (both internal and external) is essential. Apart from management teams that have balance sheets comparable to BigTech firms (such as Facebook, Apple, Amazon, Microsoft, and Google), all management teams in Azerbaijan will at some point require access to external capital, and thus they must understand the advantages and disadvantages of these sources. However, pros and cons are not solely determined by financial costs; rather, they primarily depend on the business strategy uniquely tailored to each company's specific circumstances. Therefore, there is no universal solution regarding how all companies should finance themselves.

Every company has three primary sources of financing: internal funds, debt, and equity. According to the TWC Analysis of the Global Financing Mix, the preferred order typically favors internal financing over debt, and debt over equity. This study indicates that approximately 70% of financing comes from internal sources, 20% from debt, and 5-10% from equity. Furthermore, when deciding between debt and equity, the global perspective shows that the main influencing factor is the stage of market development. Companies in developed markets tend to use equity more frequently because of better access to capital markets, stronger shareholder protections, and greater availability of private equity and venture capital financing. Conversely, companies in emerging markets, due to the opposite reasons, predominantly rely on debt financing (primarily bank loans).

To understand the advantages and disadvantages of debt and equity financing for companies in emerging markets, consider an executive director (controlling shareholder) in Azerbaijan managing Lumberwood OJSC, one of the country's largest manufacturers of wood products. Lumberwood OJSC, currently facing financial difficulties, urgently requires funding. To provide context, the company has experienced rapid growth but sells homogeneous products. Since it cannot charge premium prices based on differentiation, it must primarily compete on price, maintain strict cost controls, and foster strong customer and supplier relationships. However, high sales volume combined with minimal gross margins doesn't translate into liquidity and instead necessitates additional investments in equipment, property, and inventory, thereby creating the need for external financing. Until now, the executive director has filled this funding gap through short-term loans, but since this channel is inadequate, he must seek additional financing sources. Which financing source should the executive director choose?

If flexibility is a priority, debt—which involves interest payments, covenants, and collateral—may not be optimal. If the situation worsens or interest rates increase, Lumberwood OJSC could quickly move from profitability to loss given its thin margins and intense price competition. Loan covenants might also restrict future borrowing capacity. Thus, equity is preferable regarding flexibility.

Regarding risk, the critical question is whether Lumberwood OJSC can maintain the ability to meet interest and principal repayment obligations, even under liquidity stress. Higher debt increases the risk of default, financial distress, and bankruptcy, posing additional risks to shareholders and lenders. Thus, equity is again preferable concerning risk management.

Regarding profitability, the tax shield effect of debt interest payments is beneficial if the company's pre-tax return on assets (ROA) exceeds the borrowing rate. Under these conditions, debt financing would enhance return on equity (ROE). Therefore, debt is preferable concerning profitability.

Regarding control, the executive director must consider how issuing additional shares and the resulting dilution of ownership would affect decision-making. If the director is uncomfortable with new shareholders, increasing his personal investment in the company could be a preferable option. Hence, debt is favorable regarding maintaining control.

Regarding timing, the executive director must assess the current state of capital markets (both debt and equity), the prevailing interest rates, and market conditions for issuing shares. The choice here entirely depends on whether capital markets are favorable or unfavorable.

Other factors to consider include the attitude of the executive director and other shareholders toward debt. While debt can impose discipline on management, it may also affect the company's credit ratings adversely.

Assuming Lumberwood OJSC’s executive director does not prefer additional shareholders, optimal financing sources would either involve further personal investment by the executive director or obtaining long-term debt financing (instead of relying solely on short-term loans), or a combination of both. Additionally, other tools like asset sales, leasing, factoring, and private or venture capital financing are also available but have been omitted here to maintain simplicity.

Ultimately, there is no single optimal solution applicable to all Azerbaijani companies deciding between debt and equity financing. The best choice primarily depends on each company's individual business strategy.