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. Most companies use a combination of
both 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 his 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.