The finance for an organisation comes from both internal and external sources and most businesses use a combination of both. External or debt finance is a liability to an organisation as it is money owed to external sources. Equity finance rebates to the internal sources of finance in the organisation. Businesses must carefully consider whether to use debt or equity finance and how much of each is needed. Debt finance does not normally exceed equity finance although the design of how much debt and how much equity depends on the size and type of business.

Debt can be attractive to firms as funds are usually readily available and interest payments are tax deductible therefore reducing the cost of debt financing. The amount of debt used by businesses varies but short-term borrowing is an important source of funding for a business.

Risk and return must be carefully considered in determining whether deby or equity finance is used. For example, there is a greater level of risk associated with borrowing and consideration has to be given to the impact of borrowing on the future profitability and financial stability of there organisation.

The costs to be considered in using debt financing are:

• Repayment of principal

• Interest payments

• Timing repayments

• Administrative and legal costs associated with borrowing

• Conditions and terms of borrowing

• Tax consideration

• Maturity date of the loan as refinancing may be required

• Level of control by the lender

The following are types of debt financing and their main characteristics:

Banks – because of their size, banks can lend large sums of money to businesses. The common types of loans are mortgages, personal loans and targeted loans.

Small Lenders – they offer similar loans as banks but usually at lower interest rates and in smaller amounts due to their smaller reserves of assets.

Suppliers – they offer trade credit which allows a business to receive goods without payment. The supplier usually allows 30 days for the account to be paid.

Factoring – if a business offers trade credit but experiences a severe cash-flow shortage, they can employ a factor to buy their trade credit account at a fee.

Leasing – opposed to a business borrowing large sums of money to purchase equipment, a business may choose to lease equipment from a Lessor.

Other Lenders – these lenders will purchase cheques which take 3-5 days to clear with immediate payment at a reduced price.

Suggested Reading:

+ Holiday Debt
+ Better Credit Deal

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Tags: debt financing, Equity Financing