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Availability of money is essential for any new venture or a fresh commercial enterprise. Funds are required to support all of company expenses such as rent, employee salaries, purchase of new equipment etc. This is true for all the new companies, but the companies that are already in existence require financing to expand the business activities, renovate the offices or factories and to invest in new profit generating ventures. Such companies can raise funds by either going into debt or selling the equity, depending on different parameters.
Debt Financing means to avail a loan with a promise to repay over a specific time in addition to interest payments. A company planning to arrange funds through debt financing can do so by approaching a lending institution. Later on, the company can use the fund for any requirement as may be decided.
On the otherhand, Equity Financing
means to dispose off the equity to the investors in return for the fund. In return for the investment, the equity financiers participate in the management decisions of the company and gain access to all information regarding the performance and activities of the company on a regular basis.
Advantages
And Disadvantages Of Debt
Financing
Debt Financing is generally availed by banks and small business units. The advantages of debt
financing are:
- That the owner retains control over the business
- The interest of the debt financing is tax exempt.
There are disadvantages also. If reliance on such type of financing is extreme then it can cause a few
problems. Too much debt starts to backfire if the circumstances turn adverse.
What Is Equity Financing?
Equity Financing is similar to barter of funds for the ownership of the business. This involves no debt, thus making this option always the better proposition.
The advantages Of Equity Financing Are
- There is not much concern about repayment of the loan, because it is related to the profit making
capability of the business. As long, there is profit the lenders will be repaid adequately.
- The involvement of investors, with the business increases. If the investors have a reputation the
credibility of the business increases thus winning the attention of others in the market as well.
There are certain disadvantages of Equity Financing as well.
- The owner can loose command over the business.
In Equity Financing where banker, venture capitalist or any other investor is funding any borrower, the
important aspect for consideration is the debt equity ratio. It determines, if there is ample funds
available for repayment in case there is any default. It also reflects the liabilities of the business
to external sources.
It is not easy to select the correct option for finance. One must consider first the business motives, the amount of control, and long-term goals. With Equity Financing, a situation may develop where there may be some disagreement between the owner and the investors. In such situations, it is a better option to let the investors run business, because the selling off the business is not always a viable decision. Hence, if retaining control of the business is the paramount option one must opt for Debt Financing.
Debt Financing can be either long term or short term. Term loan is one of the ways to get long term Debt Financing. A long-term loan is arranged when the repayment of the loan and the estimated value of the assets purchased is
expected to exceed in a year. The new assets secure the long-term loans, failing which the additional funds from the shareholders secure the later portion. The lenders make the loans to that business that can show a steady repayment schedule, thus making it mandatory for a specific business plan including cash flow.
It must demonstrate the debtors business ability to repay the loan along with the interest over the term of the repayment schedule.
A proper insurance of the assets is also advisable in these circumstances. Different lenders make different term loans, which can carry different rate of interest and often-low interest rates as the term is fixed, unlike other loans. Different types of loan security agreements are:
Promissory Notes It is a written assurance to pay a specified sum of money to the lender either on demand or on a specified date.
Realty Mortgage It is a loan whose takings are applied to the purchase or refinance of land and
buildings.
Chattel Mortgage It is a loan on a specific asset besides land and building. A lien charge against the title is registered with the province.
Pledge Pledge and Chattel Loans are almost the same. The only exception being the possession is transferred to the lender but the title remains with the borrower.
Floating charge This assigns that all the remaining assets and debentures, not mortgaged as security for other debts will be taken as the security for the new debts.
The certainty of the repayment and the command over the loan securities makes the long term financing the preferred method of debt financing.
Debt Financing over a short term applies to funds required to support daily operational expenses. Primarily for the inventory, supplies, or paying the wages to the employees. It is also referred as an operating loan or short-term loan because the repayment takes place within a year.
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