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 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.

There are two main types of financing available for companies: debt and equity. 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.

BREAKING DOWN '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 percent 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.

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. Some lenders require collateral. For example, assume the owner of the grocery store also decides that she needs a new truck and must take out a loan for $40,000. The truck can serve as collateral against the loan, and the grocery store owner agrees to pay 8 percent interest to the lender until the loan is paid off in five years. Debt is easier to obtain for small amounts of cash needed for specific assets, especially if the asset can be used as collateral. While debt must be paid back even in difficult times, the company retains ownership and control over business operations.

The Weighted Average Cost of Capital (WACC)

Firms will decide the appropriate mix of debt and equity financing by optimizing the average weighted cost (WACC) of each type of capital while taking into account the risk of default or bankruptcy on one side and the amount of ownership owners are willing to give up on the other. Because interest on debt is typically tax-deductible, and because the interest rates associated with debt is typically cheaper than the rate of return expected for equity, debt is usually preferred. However, as more debt is accumulated, the credit risk associated with that debt also increases and so equity must be added to the mix. Investors also often demand equity stakes in order to capture future profitability and growth that debt instruments do not provide.

WACC is computed by the formula:

WACC = x Re + x Rd x (1 – Tc)

Where:

RELATED TERMS
  1. Cost of Capital

    Cost of capital is the required return necessary to make a capital ...
  2. Optimal Capital Structure

    An optimal capital structure is the mix of debt, preferred stock and common ...
  3. Weighted Average Cost of Capital ...

    The calculation of a firm's cost of capital in which each source ...
  4. Equity Financing

    If a company needs capital to support its growth, it might seek ...
  5. Long-Term Debt To Capitalization ...

    A ratio showing the financial leverage of a firm, calculated ...
  6. Cost of Debt

    Cost of debt is the effective rate that a company pays on its ...
Related Articles
  1. Small Business

    Is Equity Financing the Right Choice for Your Business?

    Discover the benefits and drawbacks of equity financing for a small business, and learn when equity financing should be used instead of debt financing.
  2. Small Business

    The basics of financing a business

    From debt financing to equity financing, there are numerous ways to fund a business startup. Find out which one is the best funding model for your company?
  3. Personal Finance

    What to know for an investment banking interview

    Find out what you need to know and how to prepare for an investment banking interview.
  4. Personal Finance

    Why Debt Isn’t Always a Bad Thing

    When managed properly, debt can be used to achieve a higher overall rate of return.
  5. Investing

    Lowe's Stock: Capital Structure Analysis (LOW)

    Examine Lowe's Companies' equity capitalization, debt capitalization and enterprise value to analyze trends in the retailer's capital structure.
  6. Insights

    The National Debt Explained

    We know it's growing, but we don't know exactly how. An in-depth look why the U.S. Government's debt continues to balloon and what it all means for you.
  7. Personal Finance

    Sizing Up Debt

    Ever wonder if the different types of debt are good or bad? Read on and we'll tell you.
  8. Investing

    Equity Multiplier

    The equity multiplier is a straightforward ratio used to measure a company’s financial leverage. The ratio is calculated by dividing total assets by total equity.
  9. Investing

    Debt Ratio

    The debt ratio divides a company’s total debt by its total assets to tell us how highly leveraged a company is—in other words, how much of its assets are financed by debt. The debt component ...
RELATED FAQS
  1. How does a company choose between debt and equity in its capital structure?

    Learn about the benefits and drawbacks of debt and equity financing. Find out how to compare capital structures using cost ... Read Answer >>
  2. What's the formula for calculating WACC in Excel?

    Learn about the weighted average cost of capital (WACC) formula and how it is used to estimate the average cost of raising ... Read Answer >>
  3. What is the formula for calculating weighted average cost of capital (WACC)?

    Weighted average cost of capital (WACC) is the average after-tax cost of a company's various capital sources used to finance ... Read Answer >>
  4. What is the difference between cost of debt capital and cost of equity?

    Learn about how the costs of debt and equity capital differ and how to calculate each using interest and tax rates and stock ... Read Answer >>
  5. Which financial ratio best reflects capital structure?

    Learn about the debt-to-equity ratio and why this metric is widely considered the most useful reflection of a company's capital ... Read Answer >>
  6. What is the difference between the cost of capital and the discount rate?

    Learn about the differences between the cost of capital and the discount rate as they relate to estimating a required return ... Read Answer >>
Hot Definitions
  1. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  2. Current Assets

    Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
  3. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  4. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  5. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
  6. Depreciation

    Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account ...
Trading Center