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Table of Contents

What Is Financing?

Understanding Financing

Types of Financing

Special Considerations

Example of Financing

Frequently Asked Questions (FAQs)

The Bottom Line

Personal Finance Loans

Financing: What It Means and Why It Matters

By Adam Hayes Updated June 08, 2023

Reviewed by Thomas Brock

Fact checked by Suzanne Kvilhaug

Financing

Investopedia / Theresa Chiechi

Definition

Financing is the business of providing or raising funds.

What Is Financing?

Financing is the process of providing funds for business activities, making

purchases, or investing. Financial institutions, such as banks, are in the
business of providing capital to businesses, consumers, and investors to help
them achieve their goals. The use of financing is vital in any economic
system, as it allows companies to purchase products out of their immediate
reach.

Put differently, financing is a way to leverage the time value of money (TVM)
to put future expected money flows to use for projects started today.
Financing also takes advantage of the fact that some individuals in an
economy will have a surplus of money that they wish to put to work to
generate returns, while others demand money to undertake investment (also
with the hope of generating returns), creating a market for money.

Key Takeaways

Financing is the process of funding business activities, making purchases, or

investments.

There are two types of financing: equity financing and debt financing.

The main advantage of equity financing is that there is no obligation to repay

the money acquired through it. Equity financing places no additional financial
burden on the company, though the downside is quite large.

Debt financing tends to be cheaper and comes with tax breaks. However,
large debt burdens can lead to default and credit risk.

The weighted average cost of capital (WACC) gives a clear picture of a firm's
total cost of financing.

Understanding Financing

There are two main types of financing available for companies: debt
financing and equity financing. Debt is a loan that must be paid back often
with interest, but it is typically cheaper than raising capital because of tax
deduction considerations. Equity does not need to be paid back, but it
relinquishes ownership stakes to the shareholder. Both debt and equity have
their advantages and disadvantages.

Important

Most companies use a combination of both debt and equity to finance

operations.

Types of Financing

Equity Financing

"Equity" is another word for ownership in a company. For example, the owner
of a grocery store chain needs to grow operations. Instead of debt, the owner
would like to sell a 10% stake in the company for $100,000, valuing the firm
at $1 million. Companies like to sell equity because the investor bears all the
risk; if the business fails, the investor gets nothing.

At the same time, giving up equity is giving up some control. Equity investors
want to have a say in how the company is operated, especially in difficult
times, and are often entitled to votes based on the number of shares held.
So, in exchange for ownership, an investor gives their money to a company
and receives some claim on future earnings.

Some investors are happy with growth in the form of share price
appreciation; they want the share price to go up. Other investors are looking
for principal protection and income in the form of regular dividends.

Advantages of Equity Financing

Funding your business through investors has several advantages, including

the following:
The biggest advantage is that you do not have to pay back the money. If
your business enters bankruptcy, your investor or investors are not creditors.
They are part-owners in your company, and because of that, their money is
lost along with your company.

You do not have to make monthly payments, so there is often more cash on
hand for operating expenses.

Investors understand that it takes time to build a business. You will get the
money you need without the pressure of having to see your product or
business thriving within a short amount of time.

Disadvantages of Equity Financing

Similarly, there are a number of disadvantages that come with equity

financing, including the following:

How do you feel about having a new partner? When you raise equity
financing, it involves giving up ownership of a portion of your company. The
riskier the investment, the more of a stake the investor will want. You might
have to give up 50% or more of your company, and unless you later
construct a deal to buy the investor's stake, that partner will take 50% of
your profits indefinitely.

You will also have to consult with your investors before making decisions.
Your company is no longer solely yours, and if the investor has more than
50% of your company, you have a boss to whom you have to answer.

Debt Financing

Most people are familiar with debt as a form of financing because they have
car loans or mortgages. Debt is also a common form of financing for new
businesses. Debt financing must be repaid, and lenders want to be paid a
rate of interest in exchange for the use of their money.

Some lenders require collateral. For example, assume the owner of the
grocery store also decides that they need a new truck and must take out a
loan for $40,000. The truck can serve as collateral against the loan, and the
grocery store owner agrees to pay 8% interest to the lender until the loan is
paid off in five years.
Debt is easier to obtain for small amounts of cash needed for specific assets,
especially if the asset can be used as collateral. While debt must be paid
back even in difficult times, the company retains ownership and control over
business operations.

Advantages of Debt Financing

There are several advantages to financing your business through debt:

The lending institution has no control over how you run your company, and it
has no ownership.

Once you pay back the loan, your relationship with the lender ends. That is
especially important as your business becomes more valuable.

The interest you pay on debt financing is tax deductible as a business

expense.

The monthly payment, as well as the breakdown of the payments, is a known

expense that can be accurately included in your forecasting models.

Disadvantages of Debt Financing

Debt financing for your business does come with some downsides:

Adding a debt payment to your monthly expenses assumes that you will
always have the capital inflow to meet all business expenses, including the
debt payment. For small or early-stage companies, that is often far from
certain.

Small business lending can be slowed substantially during recessions. In

tougher times for the economy, it's more difficult to receive debt financing
unless you are overwhelmingly qualified.

Special Considerations
The weighted average cost of capital (WACC) is the average of the costs of
all types of financing, each of which is weighted by its proportionate use in a
given situation.

By taking a weighted average in this way, one can determine how much
interest a company owes for each dollar it finances. Firms will decide the
appropriate mix of debt and equity financing by optimizing the WACC of each
type of capital while taking into account the risk of default or bankruptcy on
one side and the amount of ownership owners are willing to give up on the
other.

Because interest on the debt is typically tax deductible, and because the
interest rates associated with debt is typically cheaper than the rate of return
expected for equity, debt is usually preferred. However, as more debt is
accumulated, the credit risk associated with that debt also increases and so
equity must be added to the mix. Investors also often demand equity stakes
in order to capture future profitability and growth that debt instruments do
not provide.

WACC is computed by the formula:

WACC

+
(

where:

Market value of the firm’s equity

Market value of the firm’s debt

R
e

Cost of equity

Cost of debt

Corporate tax rate

WACC=(

×Re)+(

×Rd×(1−Tc))

where:

E=Market value of the firm’s equity

D=Market value of the firm’s debt

V=E+D

Re=Cost of equity
Rd=Cost of debt

Tc=Corporate tax rate

Example of Financing

Provided a company is expected to perform well, you can usually obtain debt
financing at a lower effective cost. For example, if you run a small business
and need $40,000 of financing, you can either take out a $40,000 bank loan
at a 10% interest rate, or you can sell a 25% stake in your business to your
neighbor for $40,000.

Suppose your business earns a $20,000 profit during the next year. If you
took the bank loan, your interest expense (cost of debt financing) would be
$4,000, leaving you with $16,000 in profit.

Conversely, had you used equity financing, you would have zero debt (and as
a result, no interest expense), but would keep only 75% of your profit (the
other 25% being owned by your neighbor). Therefore, your personal profit
would only be $15,000, or (75% x $20,000).

Is Equity Financing Riskier Than Debt Financing?

Equity financing comes with a risk premium because if a company goes

bankrupt, creditors are repaid in full before equity shareholders receive
anything.

Why Would a Company Want Equity Financing?

Raising capital through selling equity shares means that the company hands
over some of its ownership to those investors. Equity financing is also
typically more expensive than debt. However, with equity there is no debt
that needs to be repaid and the firm does not need to allocate cash to
making regular interest payments. This can give new companies extra
freedom to operate and expand.

Why Would a Company Want Debt Financing?

With debt, either via loan or a bond, the company has to make interest
payments to creditors and ultimately return the balance of the loan.
However, the company does not give up any ownership control to those
lenders. Moreover, debt financing is often cheaper (due to a lower interest
rate) since the creditors can claim the firm's assets if it defaults. Interest
payments of debts are also often tax-deductible for the company.

The Bottom Line

Many businesses eventually need greater spending power in order to grow,

and financing is the most common method of attaining it. There are pros and
cons to both debt and equity financing, and each company should carefully
weigh the costs of each before making a decision.

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