What Is Financing?
Financing is how you raise money for things like starting a business, buying something, or investing. You can borrow it through debt financing from banks or other lenders, or you can bring in investors via equity financing, where you give up some ownership in exchange for their cash. This approach lets you keep your own money for other uses while tapping into someone else's capital for what you need right now.
Key Takeaways
Financing lets you get the cash to fund your business activities, investments, or purchases. Remember, there are two types: debt and equity. Debt is usually cheaper and comes with tax advantages. With equity, you don't have to repay the money, which is its biggest plus.
Understanding Financing
For companies, the main options are debt financing and equity financing. Debt means taking a loan that you pay back with interest, but it's often less expensive overall because of tax deductions on that interest. Equity doesn't require repayment, but you hand over ownership to shareholders. Both have their upsides and downsides.
Financing leverages the time value of money, letting you use expected future cash flows for projects starting today. It connects people with extra money looking for returns to those who need funds for investments, creating a whole market for capital.
Most companies mix debt and equity to finance their operations—it's rarely one or the other.
Types of Financing
Let's break this down starting with equity financing. Equity means ownership in your company. Say you're running a grocery store chain and want to expand. You could sell a 10% stake for $100,000, putting the company's value at $1 million. Companies prefer this because the investor takes all the risk—if things go south, they lose out, not you.
But giving up equity means giving up control. Investors get a say in operations, especially when times are tough, and they vote based on their shares. In return for their money, they claim a piece of future earnings. Some investors chase growth through rising share prices, while others want steady dividends for income and protection.
Funding through investors has clear advantages. The top one is no repayment—if your business tanks, investors aren't creditors; they're owners who lose with you. No monthly payments mean more cash for operations. Plus, investors know building a business takes time, so there's less pressure to succeed fast.
On the flip side, disadvantages include sharing ownership. You're essentially getting a new partner, and for riskier ventures, they might demand a big stake, like 50% or more, taking half your profits forever unless you buy them out. You'll need to consult them on decisions, and if they own over half, they're basically your boss.
Now, debt financing. You're probably familiar with it from car loans or mortgages. For businesses, it's common too—you borrow, repay with interest. Lenders might want collateral, like if you need a $40,000 truck loan at 8% interest over five years; the truck secures it. Debt works well for small amounts tied to specific assets that can collateralize the loan. Even in tough times, you repay, but you keep full ownership and control.
Advantages here include no lender control over your operations—they don't own any part of your company. Once repaid, the relationship ends, which matters as your business grows in value. Interest is tax-deductible, and payments are predictable for forecasting.
Disadvantages? Debt adds to your monthly expenses, assuming you'll always have cash flow to cover it, which isn't guaranteed for startups. During recessions, getting loans gets harder unless you're highly qualified.
Special Considerations
The weighted average cost of capital (WACC) averages the costs of all your financing types, weighted by how much you use each. It shows how much interest you owe per dollar financed. Companies optimize their debt-equity mix by balancing WACC against default risks and how much ownership they're willing to give up.
Debt is often preferred because interest is tax-deductible and rates are lower than equity returns. But piling on debt raises credit risk, so you add equity to balance it. Investors want equity for a shot at future profits that debt doesn't offer.
The WACC formula is: WACC = (E/V × Re) + (D/V × Rd × (1 - Tc)), where E is equity market value, D is debt market value, V is E + D, Re is cost of equity, Rd is cost of debt, and Tc is the corporate tax rate.
Example of Financing
If your company is set to do well, debt often costs less effectively. Say you need $40,000 for your small business. You could get a bank loan at 10% interest or sell a 25% stake to a neighbor for that amount.
If you earn $20,000 profit next year, the loan's $4,000 interest leaves you with $16,000. With equity, no debt means you keep 75% of profits, so $15,000—debt wins here.
Is Equity Financing Riskier Than Debt Financing?
Equity carries a risk premium because in bankruptcy, creditors get paid first, and equity holders might get nothing.
Why Would a Company Want Equity Financing?
Selling equity shares means giving up ownership, and it's usually pricier than debt. But no repayment frees up cash, giving new companies room to grow without interest pressures.
Why Would a Company Want Debt Financing?
Debt requires interest payments and eventual repayment, but you keep ownership. It's often cheaper due to lower rates and tax-deductible interest, plus lenders can seize assets on default.
The Bottom Line
Businesses need more spending power to grow, and financing is the go-to method. Debt and equity both have pros and cons— weigh them carefully before deciding.
Other articles for you
Relative value is a method to assess an asset's worth by comparing it to similar assets, contrasting with intrinsic value which focuses solely on the asset itself.
The average daily balance method calculates credit card interest by averaging the daily balances over the billing period.
Thrifts are savings and loan associations that focus on higher interest savings and real estate lending, differing from commercial banks in their member-oriented approach and access to federal borrowing.
Workers' Compensation Coverage B provides additional insurance for employer liability beyond standard state requirements, covering medical costs, lost wages, and more for injured employees.
Asset allocation involves dividing an investment portfolio among different asset classes to balance risk and reward based on individual goals and circumstances.
Negative amortization occurs when unpaid interest on a loan is added to the principal balance, causing it to increase instead of decrease.
The text explains what a dividend rate is, how it's calculated, and related concepts like payout ratios and dividend aristocrats.
An indifference curve illustrates combinations of two goods that provide equal utility to a consumer in microeconomics.
Lucrative refers to any venture or activity that generates substantial profit after accounting for costs.
Bond futures are contracts that allow traders to buy or sell government bonds at a fixed future price to hedge against or speculate on interest rate changes.