Financing is the process of providing funds for various business activities, making purchases, or investing. Financial institutions, such as banks, offer capital to businesses, consumers, and investors to help them achieve their goals. The use of financing is fundamental in any economic system, as it allows companies to acquire products and services that might be beyond their immediate financial reach.
Put differently, financing leverages the time value of money to put future expected money flows to use for projects that begin today. It also captures the market dynamics where individuals with a surplus of money seek investment opportunities, while others look for funds to undertake new projects, all with the hope of generating returns.
Key Takeaways
- Financing is about funding business activities, making purchases, or investments.
- There are two primary types of financing: equity financing and debt financing.
- The main advantage of equity financing is the absence of repayment obligations, however, it does come at the cost of relinquishing some ownership control.
- Debt financing is typically cheaper and offers tax breaks, but it brings the risk of default and credit issues.
- The weighted average cost of capital (WACC) gives a complete picture of a firm’s overall financing cost.
Understanding Financing
Mainly, companies have two avenues for financing: debt financing and equity financing. Debt involves a loan that must be repaid, often with interest, and tends to be cheaper due to tax benefits. Equity, however, does not require repayment but involves relinquishing ownership stakes to shareholders. Each has distinct advantages and disadvantages.
Most companies prefer a balanced combination of both debt and equity to meet their financing needs.
Types of Financing
Equity Financing
“Equity” signifies ownership in a company. For example, if the owner of a grocery store chain aims to expand, they might sell a 10% stake in their company for $100,000, valuing the firm at $1 million. Companies like selling equity because the risk falls on the investor — if the business doesn’t succeed, the investor gets nothing.
However, giving up equity means losing some control. Equity investors want a say in corporate operations, especially during difficult times, and are often entitled to votes based on the number of shares they own.
Advantages of Equity Financing
- No Repayment Obligations: If your business goes bankrupt, your investors are not creditors but part-owners who risk losing their investment along with the company.
- Reinvestment Opportunities: Without monthly payback schedules, companies retain more cash for operating expenses.
- Investor Patience: Equity investors often understand that business growth takes time.
Disadvantages of Equity Financing
- Losing Control: Gaining equity partners means giving up a portion of company ownership. The riskier the venture, the larger the stake investors will demand. You might end up sharing significant portions of the company’s profit indefinitely.
- Decision Sharing: Every major decision needs investor consultation, especially if they hold more than 50% ownership.
Debt Financing
Most people recognize debt as a common financing method, considering familiar consumer examples such as car loans or mortgages. Similar to personal finances, businesses can use debt financing, which demands repayment with an added interest cost. Often, collateral is required.
Debt is suitable for smaller cash amounts meant for specific assets. Although companies are obligated to repay this debt regardless of financial strife, they retain full ownership and control over their operations.
Advantages of Debt Financing
- No Ownership Dilution: Lenders have no say in company operations or ownership.
- Definitive Timeline: After repayment, the relationship with the lender ends, valuable as the business grows.
- Tax Deductions: Interest payments are typically tax deductible, lowering the overall cost.
- Predictable Expenses: Detailed payment schedules are known expenses for accurate forecasting.
Disadvantages of Debt Financing
- Fixed Repayments: Adding debt repayments to monthly expenses requires assured cash flow, which might not always be certain for small businesses.
- Economic Sensitivity: Securing debt financing can become challenging during economic recessions.
Special Considerations
The [weighted average cost of capital (WACC)] is the average cost of all financing types a company uses, weighted by their respective usage proportions. This metric helps determine how much interest a company owes for each financed dollar. Companies leverage WACC to find an optimal mix of debt and equity while balancing the risks of default or over-extending equity stakes.
Interest on debt is usually tax-deductible, and the cost of debt often falls below the expected rate of return for equity, often making debt the preferred option. Nonetheless, excessive debt raises credit risk, necessitating some equity injection. Investors may also seek equity stakes to capture profitability and growth potentials beyond what debt offers.
WACC Formula:
1WACC = ( E / V × Re ) + ( D / V × Rd × ( 1 − Tc ) )
2where:
3E = Market value of the firm's equity
4D = Market value of the firm's debt
5V = E + D
6Re = Cost of equity
7Rd = Cost of debt
8Tc = Corporate tax rate
Example of Financing
If a small business requires $40,000, it can opt for a bank loan with a 10% interest rate or sell a 25% ownership stake for the same amount.
Consider earning $20,000 in profit next year. Using a bank loan, the interest cost (debt financing cost) would be $4,000, leaving $16,000 in profit. Alternatively, using equity financing, with no debt and no interest expenses, you would retain 75% of your profit, equaling $15,000 (75% × $20,000).
Comparing Equity Versus Debt Financing
Is Equity Financing Riskier Than Debt Financing?
Equity inherently carries a risk premium as creditors get repaid before equity shareholders in case of bankruptcy.
Benefits of Equity Financing for Companies
Raising capital through equity means ceding some ownership, but it frees companies from debt obligations and interest payments, providing flexibility for growth.
Benefits of Debt Financing for Companies
Debt involves regular interest payments but avoids diluting ownership control. It is often cheaper because, upon default, creditors can claim company assets. Moreover, interest payments are typically tax deductible.
The Bottom Line
Businesses often require increased spending power for growth, and financing is prevalent for achieving this. Both debt and equity financing have distinct pros and cons. Companies must carefully evaluate these aspects to determine the best approach for their financial strategies.
Related Terms: financial institutions, time value of money, collateral, corporate tax rate.
References
- The Hartford. “Advantages vs. Disadvantages of Equity Financing”.
- American Express. “What Is Debt Financing? Is It Right For My Business?”
- Internal Revenue Service. “Publication 535 (2022), Business Expenses”.
- Harvard Business School. “Cost of Capital: What It Is And How To Calculate It”.
