WHAT IS FINANCING | MEANING AND TYPES
The previous notes covered the basics of finance, i.e. what is finance and what are the various types of finances.
Here’s the link to the previous note: http://universeofthoughts.com/finance-types/
In this note, we will understand, ‘What is financing?’
Finance and financing are different terms.
Finance relates and describes the system of money and how it flows whereas financing relates to the sources from which one can get a certain monetary base which is basically money. In these notes both meaning and types of financing are covered.
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.
Types of financing:
Debt Financing :
Debt financing does not give the lender ownership control, but the principal must be repaid with interest. Length of the loan, interest rates, security and other terms depend upon for what the loan is being used. There are three types of terms for debt financing as mentioned below:
Loans for short periods (mostly upto 1 year) usually made to cover temporary or seasonal needs for inventory or personnel. These are common for established businesses, but may be hard for a new business to obtain. The key to getting a short-term loan is to always have an identified primary and secondary source of repayment. A short-term loan will probably be either a time loan or a line of credit, both with maturities of one year or less.
Medium to long term:
These loans may be repaid over anywhere from 1 to 5 to even 20 years depending on how the funds are used. The source of repayment is the cash flow of the business. Typical uses are for equipment, fixed assets, etc. Most loans to start a small business will be of this type. Often referred to as term loans or installment loans, these usually cost more than short-term credit. The most common uses for long-term loans are to provide working capital, to purchase equipment, or to buy or improve land and/or buildings.
Working capital loans represent funding for all purposes that are not fixed assets or a line of credit. Examples could be general and administrative funds for expanding the business, a percentage of the purchase of permanent assets, the costs of building out leased space or for purchasing furniture, fixtures, or computer and automotive equipment. Loans for equipment generally will be extended for a term consistent with the depreciable value of the assets.
Long term debt can be repaid over several decades which can last upto 3 to 4 decades. Real estate is typically financed over a fairly long term, 10 to 30 years.
In its most basic form, equity financing results in the repayment of principal and/or return only if the venture produces sufficient funds/revenues for that purpose; hence the term risk capital. Due to the risk/risks, the possible capital sources could be anyone, anywhere, anytime depending on the amount, purpose, and stage of business at issue. Equity financing will always require consideration of ownership, profit, benefit sharing, operational control, valuation, and exit strategies as important issues to be carefully evaluated.
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.