Video report on debt financing and equity financing

Hi, this is Mitch Minglana. In this video, I will talk about the debt financing and equity
financing and I will also include or state few examples on this topic for better
understanding.

When a company runs out of money to finance its working capital or an acquisition, they
will borrow money from individual or institutional investors in order to run their
business. And in return, the money that they borrowed will be paid at a future date with
interest and this is what we called DEBT financing.

Debt financing in simple sense occurs when a company borrows money in order to
operate. Or acquire funds from third party to expand the company’s operation and/or to
purchase an asset by taking out a loan.

Debt financing is a time bound activity or it has a certain period of time that the borrower
needs repay the loan from the lender along with interest. The payments could be made
monthly or half a year or may it be at the end of the loan tenure.

For example, Mitch owns a coffee shop and she has been in business for over 13 years.
For quite some time, Mitch considers expanding its business due to the high demand. But
her funds is not sufficient enough so she visit the bank nearby her shop and discuss about
the potential of financing with debt to leverage her coffee shop business operation. The
bank agreed to lend money to Mitch and they suggest that Mitch gets a loan amounting to
10million for 25years at 10% interest rate. To secure the loan, the bank asks Mitch to put
her shop assets as collateral and agree that in case her business default, she will repay the
bank in cash. So that how debt financing works.

Some examples of this are bank loan, loans from family, friends or credit card loans.
Bank loan is the most common form of debt financing in which the company will borrow
money from the bank and the bank will assess the company’s financial situation to further
agree how much they can offer as well as the interest rate. While the loans from family
or friends are borrowing money from them through a credit card. These loans from
family or friends are most common in start up business or small businesses.

Debt financing can be categorized into two. May it be in long term debt financing and
short term debt financing depending on the loan preference that the company is seeking.

Long term debt financing is usually used for purchasing assets in the business. It includes
equipment, building, machinery or land and the lender will require the assets being
purchased serve as collateral for the loan. Long term debt financing generally matures in
more than 1 year and sometimes much longer. It is most likely to have fixed interest
rates.

Inversely, short term debt financing is a company’s financial obligations that mature
within a year. It is usually applies for day to day operation of the business. Some
examples of short term debt are short term bank loans, supplies, paying the wages of
employees or purchasing inventory.

Short term debt financing is commonly used in businesses where it experiencing shortage
of its cash flow or when the business sales revenue is not sufficient enough to cover the
current expenses.

For example, Due to the pandemic, Mitch coffee shop is financially downslide because of
low demand and she had existing obligations that need to pay such as salaries and wages
of her employees and income taxes. So she visits any bank nearby her shop and discuss
about financing the debt and so the bank agree to offer mitch certain amount of money
that matures within 1 year along with interest rate.

The sum up the long term and short term debt financing, I provided a table to spot the
differences between the two.
Short term financing Long term financing
Floating rate Fixed interest rate
Supplied by a bank Supplied by institutional investor
Used for short term needs of the business Used for long term initiatives.

Now let’s move to the advantages and disadvantages of debt financing.

The main advantage of debt financing is the lender or the third party does not take an
equity position in your business and has no control over it. The business owner can retain
the full ownership.

Debt financing interest costs are fully tax deductible as expense of the business. In case
of long term debt financing, the repayment period can be much longer or can extended
over many years, reducing the monthly expense.

Other benefits of debt financing include:

 Leverage for business owner’s equity
 It gives stability for planning and budgeting of the business
And many more

Disadvantages of debt financing:

For extended debt financing, banks normally require the borrower or the business owner
to let their assets of the business posted as collateral for the loan. As for my personal
opinion, as an owner of a business when you borrowed money from third party to finance
your business will leave you responsibility for paying back the loan along with its
interest. If your business is unable to make payments on the agreed period, whatever
assets you posted as collateral may it be building, car, investment accounts etc. it can be
seized by the third party or the lender.

It is difficult for a business to expand especially when it has fixed scheduled repayment
of loan. Well for some, if their business works very well then the burden of paying their
loan is not a problem. But if it has low sales revenue for quite some time, then paying the
loan seem to be a big burden for a business owner.

https://www.thebalancesmb.com/debt-financing-2947067