Financing refers to the methods and types of funding a business uses to sustain and grow its operations. It consists of debt and equity capital, which are used to carry out capital investments, make acquisitions, and generally support the business. This guide will explore how managers and professionals in the industry think about the financing activities of a company.
On a company’s cash flow statement, there is a section that’s referred to as cash flow from financing activities, which summarizes how the business was funded over a particular period.
Managers of businesses have two choices when it comes to funding activities: debt or equity. There are pros and cons to each, and the optimal choice is often a combination of each.
Characteristics of debt financing:
A loan that must be repaid
Bears an interest expense
Has a maturity date
Must be repaid before equity in the event of insolvency
Cheaper than equity capital
Adds risk to the business
Characteristics of equity financing:
Direct ownership in the company
Has no interest payments, but may have a dividend
Permanent capital, no maturity (except for certain types of preferred shares)
Last to be repaid
More expensive than debt
The decision between debt vs equity financing is what ultimately determines a company’s capital structure. The optimal capital structure for a business is typically considered that which results in the lowest weighted average cost of capital (WACC). While that’s true in theory, in practice, managers of firms tend to have preferences depending on how risk averse they are.
A firm’s WACC is a function of the cost of debt and the cost of equity, expressed in the following formula:
When managers of business think about their financing strategy, there are many factors that need to be taken into account.
Thank you for reading this CFI guide to financing, what it is, and why it matters. CFI is the official provider of the FMVA certification program, designed to help anyone become a world-class financial analyst. To learn more and advance your career, these additional CFI resources will be helpful: