Have you ever wondered how businesses raise financial capital? In this article, we will explain all about financial capital and what it entails.

What is Financial Capital?

Financial capital is what companies use to make investments in their businesses. They acquire machinery, buildings, or materials with capital, which they then use to produce goods or provide services. To run a business that will generate income, financial capital is necessary. 

How Financial Capital Works

The two most common types of financial capital are debt and equity financing. These two are used by businesses to finance and invest in their business. There are also smaller sources where businesses could get capital, like personal savings, grants, and revenue. These three are not as popular as debt and equity, but they are also sources from which a business can get capital.

Debt Financing 

Debt is money or resources borrowed for a particular period. For people not in the business world, the idea of starting your business with debt seems like a bad idea, but in reality, it’s not. 

Debt financing is borrowing money from a lender or bank to raise capital, which must be repaid in the future. They raise this capital by selling debt instruments like loans and bonds to individuals or investors as a trade-off for credit. Lenders are then owed revenue on the cash acquired. On both short-term and long-term repayment plans, lenders typically demand monthly payments.

Debt Financing Example

For instance, you want to start a crochet business but don’t have enough funds to buy all the resources you need, so you go to the bank or someone you know who can lend you the exact amount you need with the agreement that you must pay a certain percentage every month. 

You need 1000 loan from the bank or an individual investor with a 5% interest rate. That crotchet business is financed through debt financing. Every month you are liable to remit an interest rate of 5%, which is 1,510 in the original loan sum plus interest rate in the span of the year. 

Types of Debt Financing

Below are the types of debt financing.

Bank loans: For small and mid-tier businesses, bank loans are harder to secure, but they’re still a major type of debt financing. Bank loans are loans given by banks to businesses to help them meet their financial needs. Repayments must be made on a predetermined schedule and are subject to interest charges on outstanding balances. Most of the time, if you want a bank loan, you have to put up real estate or equipment as collateral. 

Bond Issues: A traditional bond certificate is sold by the debtor to the creditor. It usually includes a principal value, a repayment term agreement, and an interest rate. Individuals or businesses that purchase the bond become lenders by loaning money to the business. 

Credit card: Another way is to borrow money through a credit card. This method is common with small businesses or start-ups. 

Family and friends: This is a very common method for small businesses and startups. Borrowing money from family and friends with an agreement to pay interest over a period.

Advantages of Debt Financing

A lot of big companies use debt as financial capital for their businesses, and there are valid reasons why. While there may be some cons, there are still several advantages that make this type of financing a great option. Here are five advantages to debt financing.

Full business ownership: With debt financing, you do not have to give part of your company ownership for investments. When you finance your business through loans, you are only obligated to pay your monthly interest rates. You don’t have to worry about outside input and visions for your business because they have a stake and automatically have a say in the operations of the business. 

Tax deductions: Businesses can deduct debt financing costs from their taxable income because they are considered business expenses. You may be able to deduct the principal and interest payments from the company’s income taxes if you borrow money to finance business operations. 

Improves business credit: Utilizing debt financing can help improve your business credit score. Lenders may have difficulty determining a company’s future use of their funds if it does not have a track record of loan repayment. Meeting obligations and funding capital projects can demonstrate to other lenders and investors that the company is reliable. 

No sharing of business profits: If you pay your obligated loans or credit interest at the appropriate time, you get to keep all the profits made in that financial year. There are no investors with whom the profits accrued that year must be shared. 

Less stressful: Debt financing tends to be simpler than equity financing because there is less compliance, and you don’t have to screen equity partners or go through the complicated process of negotiating and reaching an ownership agreement. 

Disadvantages of Debt Financing

Let’s see the disadvantages of debt financing.

Business credit issues: As much as utilizing debt financing can help improve a business’s credit score, it could in the long run cause an issue if the business only uses debt as its only source of financial capital. The business will be seen as risky by investors. 

Interest rate repayment: Whether the business is making profits or losing money, at the obligated time, the interest rate for the loan collected needs to be paid to avoid property seizure.

Property and equipment risk: To take a loan, businesses need to provide collateral in the form of properties or equipment. Should a business falter on its loan repayment, they face the risk of its business and even personal properties getting repossessed by the bank.

Equity Financing

Equity financing is the process of raising capital for your business by selling a portion of the company’s equity and shares. This type of financing is usually important and popular among startups to help them finance the operation costs of the business and finance production. Investors usually get their gains from receiving dividends or when the shares they purchase rise in price.

Equity Financing Example

Using the crochet business as an example, let’s assume the business owner could not get a loan but got an investor. The investor then purchases 20% of the shares from the business, and that purchase officially gives the investor 20% ownership in the business. The business owner gets their capital, and the investor gets a small ownership stake in the business. Should the business grow in the future, the investor is obligated to take a cut in the profits.

Types of Equity Financing

Here are some types of equity financing.

Crowdfunding: Crowdfunding is when a small number of public investors invest in a business. They decide to invest in these businesses because they have faith in the concepts behind them and hope to see returns on their investments in the future. 

Corporate financing investors: This is when large corporations provide private businesses with the necessary funding by making investments in them. Typically, the purpose of the investment is to forge a strategic partnership between the two businesses. 

Venture capital funding: This is when a group of investors known as venture capital firms invest in businesses, they believe will soon be listed on stock exchanges and grow rapidly. They provide businesses with a larger stake and invest a larger sum of money.  

Initial Public Offering (IPO): This is a method by which established businesses can obtain funding. By offering their shares to the public for trading in the capital markets, companies can use the initial public offering (IPO) to raise funds. 

Angel investors: These are wealthy individuals who buy stakes in businesses they believe have the potential to earn high returns in the future. Angel investors generally also bring their business experience and connections, which helps the organization in the long haul.

Advantages of Equity Financing 

Here are some advantages of equity financing.

Beneficial to start-ups: Angel investors and venture capitalists may be particularly interested in early-stage businesses. This is due to the high return potential they may see because of their skills and experience.

No debts: There is zero financing debt as there is no repayment of initial investments. Investors prefer to see a return on their investment compared to if you took out a loan from a bank that does not benefit from your growth. It is regarded as a financing option with lower risk.

Additionally, investors are more likely than lenders to support your success due to the potential financial rewards.

Access to great business expertise: This is mostly seen with angel investors and venture capitalists who also offer access to outstanding business expertise, experience, connections, insight, and advice.

Disadvantages of equity financing 

The disadvantages of equity financing are below.

Shared ownership: In exchange for large amounts of investment from angel investors and venture capitalists, a business will have to sell a certain percentage of ownership rights to the investors.

Less decision-making power: Due to selling part of the ownership right, your decision-making power also decreases. There are certain decisions you won’t be able to make without the approval of investors, despite being the owner of the company.

High rate of return: Equity financing is thought to be more expensive than debt financing over the long term. This is because investors demand a greater rate of return than lenders. Investors take a high gamble when investing in a company and subsequently anticipate a higher yield.

Sharing business profits: Companies are obligated to share the profits accrued from the business with investors.

Personal Savings 

This is mainly seen with small businesses. Small business owners save for a particular period to get the initial capital to get their business up and running.

Grants

This is more popular in the NGO space, but grants are also a source of financial capital. Grants are a fixed amount usually awarded by charitable organizations or the government on the condition that they meet specific criteria, such as providing jobs in areas of high unemployment or executing projects.

Revenue 

This is investing revenue gotten from sales of your products and services to further expand your business. If a business is doing well and a business owner wants to expand by opening a shop in a new area, they can use the revenue and profits from their current business instead of opting for debt or equity.

Key Takeaways

• Debt financing is when a business tries to raise money by selling debt instruments to investors.
• Compared to equity financing, where investors receive securities like stocks as payment, debt financing investments must be paid back in cash.
• Financial capital is the investment that companies need to run their businesses.

FAQs

Q. What is the most common way for businesses to raise financial capital?

Ans: The two most common ways to raise financial capital are through debt or equity financing.

 Q. What are the sources of capital?

Ans: There are different sources of capital. Here are five main sources of capital for a business.

• Equity
• Debt
• Private savings
• Revenue
• Grants 

Q. What are examples of capital resources?

Ans: Capital resources are man-made assets and tools. Here are five examples of them.

• Office buildings.
• Vehicles.
• Heavy machinery.
• Inventory.
• Equipment 

Take a Quick quiz.

1. Which of these is not a type of financial capital?

1. Crowdfunding
2. Bank Loan
3. Coin funding

2. What does a business need financial capital for?

1. Acquire buildings.
2. Purchase machinery
3. All of the above

3. Do businesses that use debt financing have to pay back their loans?

1. No 
2. Yes
3. I’m not a banker, so I can’t say.