Financing is a vital aspect which is required to start a business and increase its profitability. It is also needed to tap the necessary resources for the firm. There are couple of means through which financing can be done. However the firm needs to weigh the pros and cons of each source of financing in the light of real world situations and then choose the means through which financing can be performed.
There are two major sources of financing, namely
- Debt Financing
- Equity Financing
Debt financing is the process of raising money for meeting the working capital need or capital expenditures by sale of bonds, bills, or notes. The company gets a loan and the individuals or institutions become the creditors of the business enterprise. The company promises to repay the principal amount and interest thereon within a stipulated period. The main aim of Capital Budgeting is to maximise shareholders’ wealth.
Debt financing can come either from a Lender’s Loan or through Sale of Bonds to general public.
Debt financing consists of both Secured and Unsecured Loans.
A Secured Loan requires the borrower to offer a collateral security to guarantee repayment. In case of default on loan, the collateral is forfeited to satisfy payment of the debt. Various assets are acceptable as collateral such as Guarantors, Co-makers, Real Estate, Savings Accounts or Certificate of Deposit, Chattel Mortgage.
In case of unsecured loan the credit reputation of the borrower is the only security that the lender accepts. But these are usually short-term loans carrying a very high rate of interest.
Selling bonds or commercial paper is another way to raise money through debt financing. This is more economical and easier than taking a bank loan.
Debts are also subject to a repayment period. There are three types of terms of repayment:
- Short-term loans are to be paid back within six months to 18 months.
- Intermediate-term loans are to be paid back within three years from the date of borrowing.
- Long-term loans are to be paid from the cash flow of the business within five years or less.
SOURCES OF DEBT FINANCING
Financial institutions such as banks, building societies and credit unions offer business loans, lines of credit, overdraft facilities, invoice financing, equipment leases and asset financing as both short and long term finance solutions.
Many retail stores offer store credit to purchase technology and equipments via a finance company. It carries a high interest rate.
Most suppliers offer the facility of trade credit allowing the business enterprises to delay the payment for goods.
Factor companies offer finance in the form of purchase of a business’ outstanding invoices at a discount. The factor company then chases up the debtors. While this is a simple way to get quick access to cash, it is at the same time expensive as compared to traditional financing options.
FAMILY OR FRIENDS
Offering of a loan by a friend or a relative is called debt finance arrangement.
Equity financing is the process of raising capital through the sale of an ownership interest in the form of shares.
Equity Financing involves issue of prospectus, which contains detailed information about the company’s activities, directors, risk factors, financial statements, etc to help the investor to make an informed decision regarding his/her investment.
Equity financing depends significantly on the state of financial markets and equity markets. During the Bull period, Companies find it easier to raise funds through Equity Financing while the confidence of investors shake in Bear Period and thus Debt Financing is preferable in the same.
SOURCES OF EQUITY FINANCING
Self Funding involves funding purely through personal finances and revenue from the business. It is also called ‘bootstrapping’. Investors expect some amount of self funding before they agree to offer finance to the enterprise.
Venture capital is used to finance high-risk, high-return businesses. Venture capitalists invest large sum of money in start-up businesses which have the potential for high growth and large profits. They provide management or industry expertise to the business.
Investors provide funds to the business enterprise in lieu of share in the profits and equity. Investors such as business angels can also work in the business to provide expertise in addition to providing funds.
Initial Public Offering (IPO) involves offering shares to public to raise capital. It is expensive, complex and carries the risk of not meeting the amount of minimum subscriptions.
‘Crowd Funding’ is a platform offered by social media websites to entrepreneurs for their product prototypes and innovative projects. It involves provision of project and budget details and inviting people to contribute to a start-up capital pool.
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Debt finance – money borrowed from external lenders, such as a bank.
Equity finance – investing your own money, or funds from other stakeholders, in exchange for partial ownership.
The father of Modern Finance is none other than Dr. Eugene Fama. Dr. Fama is a professor at the University of Chicago and founding board member of Dimensional Fund Advisers