Two Types of Business Financing

Basically, there are two types of business financing: debt financing and equity financing.

Debt financing refers to the money an owner borrows to start or expand a business. This money must be repaid to the lender when it comes due. For making a loan, a lender usually receive a set rate of return and the business's pledge of collateral like inventory, receivables, or other assets. Debt can be short term which due in less than one year, or long term due in two to seven years or maybe longer.

Equity financing refers to the money an owner or other people invest in a business. While debt represents the right to be repaid with interest, equity financing carries with it a share of ownership and the right to participate in earnings.

When you look for the best business financing option, you need to consider the advantages and disadvantages of both debt financing and equity financing:

Advantages of Debt Over Equity:

• Debt financing is easier to obtain than equity financing.
• You don not share your profits with the lenders who require capital appreciation and dividends on their investments.
• Interest on debt is tax deductible.
• Debt leverages the equity investor's return on investment and increase the likelihood of attracting such capital.
• Interest and principal payments are typically a know amount that can be forecast.

Disadvantages of Debt Over Equity:

• There are practical limits on how much debt your business can carry.
• Principal and interest payments can cause pressure on cash flow of small businesses.
• Debt must be repaid at some point.
• Debt instruments often have restrictive covenants that impose restrictions on the operations of the business.
• Debt financing provided by banks, insurance companies or investors often requires personal guarantees.