Last updated on July 25th, 2024 at 02:58 pm
Finance is an integral part of every business and all of its stages. In business, every day-to-day activity has a financial implication. Every employee needs to understand the financial impacts of these activities in relation to the bigger picture of the organisation.
For raising capital for business needs, organisations mainly have two financing options: equity and debt. These two financing methods have their own pros and cons, which we will discuss in detail in this blog.
If you wish to build a career in investment banking, a thorough understanding of debt and equity financing is essential. Being well-versed with financing can help develop necessary financial strategies for the company. Enrol in an investment banking course to strengthen your financial knowledge and skills and boost your resume.
What is Financing?
Simply put, providing funds for various business activities, investing and making purchases constitute financing. Financial institutes provide capital to businesses, investors and consumers to help them achieve their financial goals, usually to earn profit from that investment in future.
Types of Financing
As we have already mentioned before, there are two main types of financing — debt financing and equity financing. For anyone who wants to build a career in banking and finance, it is essential to understand the concepts of debt and equity. Let us understand these two types in detail.
What is debt financing?
The process of borrowing money without leveraging your ownership rights is known as debt financing. It involves borrowing a certain amount of money, which has to be paid back with time, along with an agreed-upon rate of interest.
Debt can either be a loan or in the form of the sale of bonds, but it does not change the borrowing conditions. Generally, the interest rate and the payback date are predetermined. There might be certain consequences if the recipient fails to pay back the amount within the specified time.
This type of financing allows you to have a clear idea about how much this financing will cost, and you do not have to share the ownership of your business. To learn more about this, enrol in a banking and finance course.
Advantages
- The lender does not have any ownership rights over the business.
- The interest paid on loans is after the deduction of taxes.
- The recipient can decide the duration of the loan.
Disadvantages
- The money has to be returned within the specified time.
- Having too much debt creates an issue in raising equity capital.
- The interest rate is usually high, downsizing any chance of growth of the company.
What is equity financing?
Equity financing can be defined as the process of raising capital by selling shares of your business to financiers. There are different sources of equity finance, such as venture capitalists, angel investors, equity crowdfunding platforms and private equity firms.
Some businesses raise several equity funds from various kinds of investors over the business lifecycle. Apart from the ownership rights, investors also get a share of the company’s future profits - dividends.
Equity investors make a return on their investment eventually by selling their shares or from dividends. These individuals have an interest in the success of the company. The right investors will also provide contacts and expertise for the growth of the business.
Advantages
- It is lower in risk as businesses do not have to pay any amount back.
- You create a network of investors, increasing the credibility of the business.
- If the business fails, there is no repayment that you have to think about.
Disadvantages
- Investors have to be consulted when making any big decisions about the company.
- You will have to share both the business's ownership and profit percentage.
- Finding the correct investors for the business commands effort and time.
Look up credible investment banking courses online to understand the two financing types and other financial modelling aspects in detail.
Debt or Equity: Which Should You Choose?
Deciding between debt and equity financing requires an in-depth understanding of the intricacies of the financial sector. An investment banking certification can help you decide the best financing option for an organisation.
Debt finance might be the correct option for you if:
- You want to remain the sole owner of your company.
- You have a consistent cash flow and a proven business module.
- You want a short-time relationship that is over with the loan repayment.
On the other hand, equity finance might be the correct option for you if:
- You have a lock of collateral or have a limited financial history.
- You do not want the burden of regular loan repayments.
- You want to grow into new markets and expand operations.
Debt and Equity Ratio
The financial ratio comparing the amount of debt to the amount of equity used for financing a business is called the debt-to-equity ratio. This ratio can be calculated by dividing the total liabilities (what the business owes others) by shareholders’ equity (total assets - total liabilities).
This metric is vital as potential investors and lenders might consider it to get an insight into the business's financial health. The higher the ratio, the riskier the investment, as the organisation may be unable to repay its debts.
However, investors and money lenders might not want to invest in businesses having a very low debt-equity ratio either. This can imply that the business hasn’t grown much, making use of the debt amount.
What is a good debt-to-equity ratio?
The answer to this question largely depends upon the industry your business is in. Organisations investing large sums of money into their asset (capital-intensive companies) often have a comparatively higher ratio.
For example, businesses in the manufacturing industry have a comparatively higher debt-to-equity ratio. On the contrary, businesses in the service industry tend to have a lower debt-to-equity ratio.
If you want to learn about the debt-equity ratio, sign up for a banking course from any credible institute.
Conclusion
Debt and equity financing are ways through which businesses acquire the necessary funding. Your ideal financing method depends on several factors, such as your business goal, need for control and tolerance for risk.
Several businesses in their startup stage pursue equity financing. On the other hand, those who are already established and those without any debt-related issues with a strong credit score might prefer debt financing.
If you want to learn about the types of financing and their implications in detail, check out Imarticus’s Certified Investment Banking Operations Professional course. This investment banker course is a flag-ship industry-approved programme designed for candidates with less than three years of job experience.
