Managing finances is key to a company's success and competitiveness. SME owners usually invest personal funds into the company when starting the business and look for external financing when the company requires additional funds. This is usually necessary for growth or to keep the business running.

The most common sources of business capital are debt financing and equity financing. In this article, we will go over the definitions of equity and debt financing, compare their differences, and outline the advantages and disadvantages of each. This will provide you with valuable insights to decide which option is better for your SME business.

What is Equity Financing?

Equity Financing is defined as offering investors a form of ownership in the business in exchange for business capital. This can be from friends and family, business angels, venture capitalists, or crowdfunding.

What Are the Advantages and Disadvantages of Equity Financing?

The main advantage of equity financing is that no interest is charged, and dividend payments are only made when the business is doing well. The investors will also have a vested interest in the business and may bring extra resources and future funding.

On the other hand, one of the primary disadvantages of equity financing is that it can lead to dilution of company ownership. Additionally, investors may require comprehensive information and reporting regarding the business. From the business owners' point of view, this restricts freedom of management and limits their access to non-monetary benefits. Equity financing is also slower than debt financing due to, legal and regulatory requirements.

What Is Debt Financing?

Debt financing is a process in which the company borrows funds from a lender or institution, and is obligated to repay the full amount with interest over some time. This financing includes business loans, credit lines, invoice financing, equipment leases and loan-based crowdfunding.

What Are the Advantages and Disadvantages of Debt Financing?

With debt financing, ownership is not diluted and funds can be obtained quicker than with equity financing. There is also no direct claim on future earnings as the repayments are predefined and the interests incurred are tax deductible.

On the other hand, debt financing might incur additional costs that could affect the profitability of the business, and business owners may need to pledge assets as collateral.

How to Determine Capital Structure of an SME?

In general, SMEs should always make use of internal resources before seeking external financing. After utilising internal resources, SMEs tend to opt for external debt financing before using equity financing. A company will seek equity financing when the loan limit is reached or when the cost of debt gets more expensive.

A 2013 paper published by the Canadian Center of Science and Education studied the capital structure of the 50 best (E50) SMEs in Malaysia. The average total debt of the E50 SMEs amounted to 53% of their total asset value, of which 11% is long-term debt versus 42% short-term debt.

According to the paper, bigger companies seek more external financing as they can diversify and better manage a higher debt ratio. On the other hand, smaller companies tend to seek short-term financing. Companies with higher growth rates tend to use retained earnings and short-term debt before using long-term debt to finance their growth. As companies become more profitable, they require less outside funding and can rely on their revenue.

What Factors Should You Consider When Choosing Between Debt and Equity Financing?

When it comes to equity financing for SMEs, the value of equity is difficult to ascertain. When pitching to investors, business owners should set fair expectations and focus on communicating both their passion and a feasible plan. It is important to be transparent and specific on how the funding will be spent, and show investors how dividends fit in the budget.

As for debt financing, business owners should create a financial budget before getting the funds. The budget should include details on how the funds will be spent, projected returns, and a clear repayment plan. The repayment plan should match the cash flow available after all current expenditures but before dividend payments. On another note, SMEs need to understand the importance of credit and build credit with honesty and integrity.

To better grow the business, SME owners need to optimise their capital structure by incorporating a mix of debt and equity. SME owners should first calculate how much funding they need and perform a cost-benefit analysis between the two types of financing. In addition, SME owners can also consider other sources of financing such as trade credit, leasing and grants if applicable.

In sum, before seeking the influx of capital, SME owners must ensure that the money is essential to achieve the goals of the business. Next, they should weigh the advantages and disadvantages of debt versus equity financing to decide on what is best for the business.  After securing funds, they should think long-term by using funds for the right purposes and motivate employees to work harder. After all, what is working capital without a little extra work?

In saying that, let us help you make things easier, in whatever way we can. Here at OCBC, we provide a variety of business financing options and financing solutions to suit your needs.