Funds One of the Most Important Decisions

¶ … Funds

One of the most important decisions that businesses have to make when sourcing for funds is whether to use equity or debt financing. Debt and equity financing happen to be the primary sources of capital for entities. In this text, I discuss these sources of financing in significant detail. In so doing, I will amongst other things highlight the main differences between them as well as the various business characteristics that make one source of financing better than the other.

Debt and Equity Financing: Key Differences

A business seeking capital has to choose from a wide range of funding sources. Such a business can either seek to borrow from banks, issue corporate bonds or get private loans from other investors with a higher risk appetite than banks. All these can be classified broadly as sources of debt financing. Commercial banks however remain the commonest debt financing sources (Kuratko and Hodgetts 2008, p. 211). On the other hand, the business can also decide to issue shares to the public through an IPO. Such a business may also approach venture capitalists or angel investors. These happen to be the main sources of equity capital. Debt capital according to Boone and Kurtz (2011, p. 576) "consists of funds obtained through borrowing." On the other hand, equity capital includes all those funds made available by the owners of an entity "when they reinvest earnings, make additional contributions, liquidate assets, issue stock to the general public, or raise capital from outside investors" (Boone and Kurtz 2011, p. 576). It therefore follows that by settling on debt financing, businesses chose to acquire a loan for which they are expected to pay at a later date. On the other hand, a business that chooses equity financing provides to those providing funds with a piece of ownership in the said entity.

It is however important to note that one form of financing may in some instances be preferred to another based on some inherent business characteristics. For instance, while businesses that are relatively well established may prefer debt financing to equity financing, new companies/startups may find equity financing more appropriate. It is important to note that in comparison to startups; well-established businesses in most cases do have a demonstrated trading history as well as solid collateral in place. This makes it easier for them to access debt financing as they are deemed less risky by providers of credit. Such businesses hence prefer debt financing as it is relatively easy to access. However, startups on the other hand tend to have poor credit ratings and do not have a trading history. Further such enterprises may also in most cases lack solid collateral. In such a case, startups may prefer equity financing which may be easier to acquire in their early stages of development. Indeed, in the opinion of Weaver and Weston (2007, p.469), entities in their early stages of development may first have to build an equity financing foundation.

Debt financing may be considered most appropriate when both the potential return and risk of a given investment happens to be relatively high. As Longenecker et al. (2005, p. 239) point out, in terms of potential profitability, the utilization of more debt than equity could result in a higher return on investment. It is important to note that the higher the number of investors involved in a certain business undertaking, the lower the return for each investor. In a way, equity financing leads to dilution of ownership. In such a case, it could be more reasonable to opt for debt financing as opposed to equity financing. This would allow for the distribution of all the available income to investors after the payment of interest and the principal amount. As Moles, Parrino and Kidwell (2011, p.648) point out, "using debt instead of equity to finance a project can increase the reported value of earnings per share." However, this according to the authors is largely dependent on the market value of a firm's shares. Debt financing also facilitates the circumvention of risk in high risk investments.

The characteristics I list above and many others not listed in this text may also influence the choice between short-term and long-term capital/fund sources. To begin with, a startup may deem it fit to fund its growth using long-term sources i.e. long-term debt financing so as to guarantee stability of earnings in the short run. In the opinion of Boone and Kurtz (2011, p.578), short-term funds tend to expose an entity to more risk. In the authors' words "short-term funds have to be renewed, or rolled over, frequently" (Boone and Kurtz 2011, p. 578). The authors also point out that in this case, there is a significantly high probability of volatility of short-term interest rates. In that regard, based on the unpredictability of its earnings, a startup would be better-off utilizing long-term sources as opposed to short-term sources.