What it means
Every business needs money before it earns money, and financing is how it bridges that gap. The gap might be short, such as paying staff before a customer settles an invoice, or long, such as building a factory that takes six years to pay for itself.
The two main categories are debt and equity. Debt must be repaid on a schedule and carries interest but leaves ownership untouched, while equity requires no repayment but permanently dilutes the existing owners' share of future profits.
Financing sits between those poles in practice. Invoice finance, asset finance, leasing, convertible notes, revenue-based funding and supplier credit are all variations that trade off cost, control, speed and security in different proportions.
The right choice depends on what the money is buying and how predictable the return is. Predictable, asset-backed spending such as vehicles or machinery suits debt, while uncertain spending such as entering a new market usually suits equity, because a lender cannot be repaid out of a plan that did not work.
Cost is measured through the weighted average cost of capital, which blends the after-tax cost of debt with the return equity holders expect. Debt looks cheaper on the surface, partly because interest is tax deductible, but it adds fixed obligations that must be met in bad years as well as good ones.
In practice
Real-world examples.
Example
A haulage operator finances eight new trucks over five years rather than paying cash, because the trucks generate revenue from day one and the lender takes security over the vehicles themselves. Ownership stays entirely with the founders.
Example
A biotechnology startup raises $12 million of equity rather than borrowing, since it will not earn revenue for four years and no lender would accept repayments from a research timetable. The founders accept dilution as the price of a funding source that cannot demand money back next quarter.
Example
A seasonal garden centre uses invoice finance and supplier credit to cover the gap between buying stock in February and selling it in May. The financing is short, expensive per year but cheap in absolute terms because it is only drawn for a few months.
Formula
Calculation
The standard measure of what financing costs is the weighted average cost of capital:
WACC = (Debt Weight x After-Tax Cost of Debt) + (Equity Weight x Cost of Equity)
After-Tax Cost of Debt = Interest Rate x (1 - Tax Rate)
Consider a distribution business funded by $4,000,000 of bank debt at 7% interest and $6,000,000 of equity where shareholders expect a 12% return. The corporate tax rate is 25%.
Total capital = $4,000,000 + $6,000,000 = $10,000,000
Debt weight = $4,000,000 / $10,000,000 = 40%
Equity weight = $6,000,000 / $10,000,000 = 60%
After-tax cost of debt = 7% x (1 - 0.25) = 5.25%
WACC = (40% x 5.25%) + (60% x 12%)
WACC = 2.10% + 7.20% = 9.30%
In cash terms, the business must generate at least $10,000,000 x 9.30% = $930,000 a year to satisfy everyone who funded it. Any project returning less than 9.30% destroys value even if it looks profitable on its own.Case study
Seen in the real world.
Pinegate Ceramics is a fictional tile manufacturer created for this illustration. It won a contract that would raise annual revenue from $6 million to $9 million, but fulfilling it required a $1.8 million kiln and roughly $600,000 of extra working capital.
The founders initially planned to raise the whole $2.4 million as equity from a regional investor, which would have handed over close to a third of the company. Working through the financing options, they instead borrowed $1.8 million against the kiln itself over seven years, funded the working capital with an invoice finance line, and raised no equity at all.
The illustrative outcome was more fixed monthly commitments and less flexibility in a bad year, but the founders kept full ownership of a business whose value rose with the new contract. The trade-off between cost, control and risk is the whole of the financing decision.
Watch out
Common mistakes.
- Judging financing by the interest rate alone, ignoring fees, security given, covenants and the effect of fixed repayments on cash flow.
- Using short-term financing such as an overdraft to fund long-term assets, which leaves the business exposed if the facility is withdrawn.
- Assuming equity is free because there is no repayment schedule, when the return investors expect is usually the most expensive money in the business.
Questions
People also ask.
What is the difference between financing and funding?
The terms overlap heavily, though financing usually implies a structured arrangement with a cost, while funding can include grants and internally generated cash.
Is debt always cheaper than equity?
Usually on paper, because interest is tax deductible and lenders rank ahead of shareholders, but it adds obligations that must be met regardless of trading conditions.
How much debt is too much?
It depends on how predictable cash flow is, and lenders typically test it through cover ratios rather than a single universal limit.
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