Choosing Between Debt Financing or Equity Financing

Finance managers world over are faced with the choice between debt financing and equity financing when looking for finance for their businesses. Both the types have certain merits and demerits. A little demystification will perhaps help towards the decision making process.

Debt financing the pro's and cons
Debt financing is basically when you take loans from financial institutions, banks or government agencies which need to be repaid over a fixed time period. Debt financing has certain advantages and disadvantages, which are listed below.

The positives
The lending institution or bank has no say in the internal decision making of the business and has no ownership in the business. There is a tax advantage since the interest on the loan is tax deductible and you can usually plan and incorporate the repayment in your budget since both principal amount and interest rate are known.

Disadvantages:
Loan repayments may be used for working capital and cause cash inflow issues ultimately affecting growth.

• Flexibility with regard to repayment time is mostly non-existent.
• Too much of debt may cause your business to be identified as high risk entity and hence negatively affecting prospects of raising additional capital in the future.
• Your business may become vulnerable if your cash flow is affected owing to several reasons, such as drop in sales. This is especially true for new businesses
• You may have to provide assets of the business as security or collateral.

Equity financing
Equity financing is when an investor finances your business in exchange for ownership of shares or stakes in the business. The investing entity reclaims the investment from future profits. The advantages and disadvantages of equity financing are as follows:

The positives

• You don't have to repay the money and hence it is less risky than a loan.
• You can access the investor's network, adding more credibility to your business.
• Your working capital is not affected due to loan repayment compulsions and business growth gets a boost.
• In case the business fails, you don't have to repay the investment.

Disadvantages

• Loss of autonomy since the investor has certain control over the functioning of your business and also shares your profit.
• You will have to consult the investor while taking decision, which may result in disagreements and friction
• At times the returns taken by the investor may outstrip interest rates payable on loans.
• Finding an appropriate investor is both time and resource consuming.

The Final Call
Both forms are essential financing tools for a business and the decision as to which tool to make use of depends on the long-term business goals and the amount of autonomy or control that you wish to retain over your business. Ideally a business needs to use both the tools according to specific situation and needs. It is usually argued that new business may be in a better position if it goes for equity financing and then gradually also includes debt financing to its portfolio. As per experts, an ideal debt-to-equity ratio for a business should be between1:1 to 1:2. Stephen Hine makes it easy for you to finance your business growth through various sources of business lending. Sign up for his turbocharged, free newsletter to find out how to grow your business using various forms of debt and equity at Australian Finance Market

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What is Debt Financing?

Almost all businesses, big or small, need to borrow money at some point. Whether it is for large assets such as land and buildings, or simply for supplies to keep a business running, debt financing plays a major role in modern business. Put simply, debt financing is the borrowing of money to keep a business running, to expand a business, or to acquire assets. Long term debt financing is usually associated with larger assets such as machinery, equipment or real estate, and it is paid back over many years. Short term debt financing, on the other hand, is most often used for business operations such as supplies or payroll, and it is often paid back within a year.

The alternative to debt financing is equity financing, which involves the acquisition of money from investors and/or savings. However, we will focus on debt financing in this article.


While most companies in Britain receive their financing from internal finance, 39 percent rely on external sources of finance, usually debt financing in the form of a bank loan. The business will agree the term of the loan and the interest rate, whether variable or fixed, with the lender. As with any loan, companies will have to show the bank how it is going to repay the money and secure the loan against an asset. The asset will usually be a premises or a piece of equipment that covers the value of the loan. In addition, a bank may require that some kind of personal asset is offered as security.

Financial institutions tend to favour companies that have good management, a reliable projected cash flow and good growth potential. The business may have to demonstrate that it can meet the monthly payments from projected revenues in its business plan. Of course, the company will have to comply with the payment schedule specified by the lending institution, and it may run into trouble if it deviates from this. Longer term loans are usually provided in this manner.


Debt financing products
Companies looking for debt finance to cover day to day running costs often opt for an overdraft instead of a long term loan, although these are falling in popularity because of high interest rates, steep fines and the obligation to repay on demand.

There are many options currently available for companies looking to avail of debt financing. Factoring and invoice discounting allow small businesses to take loans out against sales, while leasing allows for the borrowing of money to buy machinery or equipment. However, term loans remain the most popular with businesses and with banks. From the point of the view of the financial institutions, it allows them to impose regular repayment schedules over fixed periods, which is less risky than overdrafts. Many companies are known to have fallen foul of the banks because they were unable to repay overdrafts when asked. This provides an overview of the debt financing products available.


Every lending institution has its own products, rules and rates so it is worth while for any business to shop around for an arrangement that suits its needs. Some companies even offer credit cards designed for small businesses to pay for day to day incidentals. However, these can become an expensive luxury if the balance is not cleared every month.


Debt over equity
Debt financing remains more popular than equity financing for a number of reasons. Interest paid on loans can often be deducted against taxes, and debt finance is available in small, accessible amounts, whereas equity finance tends to be in large amounts. Also, with debt financing the lender has no say in how the business is run and has no rights to any ownership or profits of the business. Another advantage is that business profits can be kept within the company while the loan is used for day to day running or the acquisition of assets.

Debt financing is not a suitable option for all businesses. However, for small businesses where equity financing is not an option, it can be a valuable service in the day to day running of operations and the purchase of equipment. While loans often tend to be short term and at high interest rates, debt financing remains a popular choice for many companies.

If you are interested in learning more about debt financing, take a moment to provide us with some information, and a SimplyFinance representative will contact you to discuss what your next step should be. There are hundreds of debt financing offers available out there, so let us shop around to find the best debt financing option for you.
  http://www.simplyfinance.co.uk

Article Source: [http://ezinearticles.com/?expert=Jon_James] What is Debt Financing?