A Comparison of the Two Major Types of Financing

Looking for options of financing your business?


Financing your business is one of the major challenges of business owners. Financing is a challenge especially when the amount of paid-up capital available is limited.

Financing is a form of sourcing out funds to support business operations and to raise capital needed for business expansion for Small and Medium sized Enterprises (SMEs). Paid up capital is the initial amount the business owner puts into his business.

There are two major types of financing- Debt Financing and Equity Financing. Below are ways on how you can finance your business after taking into consideration the limited amount of paid-up capital.

1.) Debt financing

Debt financing is a form of sourcing out funds done by borrowing at a certain percentage of interest through banks or lending institutions. There is a predetermined time at which loans will mature based on the interest rates given.

Debt financing is the most favored method as it is easier to obtain. Nowadays, banks and other lending institutions are offering loans with lesser requirements. In fact, some even offer 1-day approval as long as all requirements are met.

Advantages of Debt Financing

One major advantage of debt financing is the ease of obtaining funds. Banks have set standard criteria and requirements that which when met, can lead to bank approval within a short span of time. Financial institutions will only look into the company’s ability to pay for the debt as it matures.

Another advantage of debt financing is that a business owner retains full ownership of his or her business. Creditors like banks or lending institutions do not take part of or take control over your business. Once the loan is fully paid, creditor-debtor relationship ends there. It’s only when you default on payment that the creditor can interfere in your business by exhausting all your assets to offset against amounts owing to them. Also, fixed monthly amortization has already been set by the bank including interest to be paid, so it will not be difficult for you to make a projection of your expenses.

Requirements to Obtain a Loan

What are the usual requirements to obtain a loan? Lenders will be very interested in your ability to pay, such as good cash flow for loan repayments.

The 5 Cs of Credit are: Character, Capacity, Capital, Collateral, and Conditions.

But before the bank or any lending institution can approve your loan, they will need a few requirements from you. These requirements are based on common factors used by lenders to measure the creditworthiness of the borrower, summarized as the 5 C’s of Credit. If you have passed all five, then there’s no reason why banks will not approve your loan.

Disadvantages of Debt Financing

Although debt financing may be easier to obtain, it can come at the expense of businesses that are slow growing or struggling to get off the ground.

Loan repayments become part of monthly expenses since it needs to be paid–usually–on a monthly basis. These payments can eat up a chunk of revenue earned from operations or sales. When this happens, some will opt to get another loan to repay existing loans, which is not healthy for business since it is very risky in the long run. It will also hurt your business especially if cash flow is negative.

Taking these factors into consideration, it will be a challenge for business owners to use the amount borrowed to invest in or expand their business. Depending on how well you utilize the borrowed amount, you can translate it either into earnings or more debt.

2.) Equity financing

Equity financing is a form of sourcing out fund through selling interest. It is akin to selling a portion of your company to investors who will eventually become part owners of your business.

Startups may find it difficult to market and find investors, so they usually choose to sell a portion of their business interest to relatives and friends first. As avid supporters of your business, they would understand that getting returns from their investment won’t be instantaneous. They also know that if they are patient enough, they can partake in the profit sharing once the business is doing good.

Advantages and Disadvantages of Equity Financing

The major advantage of this type of financing to business owners is that investors will shoulder all the risk. Being a part owner of the business, they can benefit from it and will get a portion of the business profits especially when the business is doing well. If the company is not performing so well, investors will suffer a loss. However, in the case that the business does go down, you as the business owner do not owe your investors any debt to pay. By selling a portion of the business, you are transferring the risk to the investors as well. On the other hand, this could also turn out to be disadvantage for the business owner as well, especially if investors will demand ownership and control. The business owner, however, can protect the business by selling only a minor percentage of the business at less than 50% interest.

Alternative Ways of Financing

Other sources of funding can be in the form of government grants. Although this may be only a few and may not be available to some countries. If government grants are available where you’re from, do take advantage of it since they usually offer zero interest rate. There are programs available for startups, which are granted to qualifying businesses that have passed very thorough requirements.

In the US, the government has a searchable directory that offers a wide selection of federal grant programs known as Grants.gov.

Which of the three methods is the best way to access capital? It would depend on the amount you will need and the level of risks involved.

Senior Finance Executive
Stone Apple Solutions Pte Ltd
Carla holds a degree in Bachelor of Science in Accountancy. She has over five years of experience in business accounting. Currently, she is based in Singapore, Singapore.

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