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SME: Debt vs. Equity Financing

SME: Debt vs. Equity Financing

  • 1 July 2023
  • By OCBC Business Banking
  • 10 mins read

Financial resources and its management are imperative to a company’s business performance and to its capacity for staying competitive in the marketplace. SME owners usually invest all their wealth into the company during the beginning stages of the business, and therefore they look for external financing when the company requires additional funds. A business may require additional funds to grow or to maintain as a stable business, or for survival purposes.

The sources of business capital are consisted of two categories, which is financing in the form of equity and debt.

Equity Financing

Equity Financing offers investors a form of ownership in the business in exchange for business capital. This form of financing is comprised of funds from friends and family, business angels, venture capitalists, and equity crowdfunding. The main advantage of equity financing is that there is no interest, and dividend payments are only made when the business is doing well. Besides, the investors will now have vested interests in the business and may bring other resources to the table as well as future funding. On the flip side, the company ownership will be diluted and investors may want comprehensive information and reporting regarding the business. From the business owners' point of view, this implies a reduction on freedom of management as well as limitation on accessing non-pecuniary benefits. Equity financing is also a relatively slower process compared to debt financing, with a lot of legal and regulatory compliance to be managed.

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 a period of time. This form of financing includes business loans, credit lines, invoice financing, equipment lease and loan-based crowdfunding. With debt financing, ownership is not diluted and funds can be obtained relatively quicker than equity financing. There is also no direct claim on future earnings as the repayments are pre-determined; and the interests incurred are tax deductible. On the other hand, debt financing will incur additional premium costs that affects profitability of the business, and assets may be required to be pledged as collateral to obtain funds.

Capital structure of well-performing SMEs

In general, SMEs should always check for internal resources, such as personal equity or retained profits, before seeking for external financing resources. After utilising internal resources, SMEs will then prefer to use 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, or if the company has better knowledge of information on its value than the market.

A 2013 paper published by the Canadian Center of Science and Education studied the variables that determined the capital structure of the 50 best (E50) SMEs in Malaysia. The average total debt of the E50 SMEs is amounted to 53% of their total asset value, of which 11% is long-term debt and 42% is short-term debt. According to the paper, bigger sized companies will seek more external financing as they can manage higher debt ratio through diversification. On the other hand, smaller sized companies tend to seek short-term financing more. Companies with higher growth rate will tend to utilise retained earnings then short-term debt before seeking long-term debt to finance their growth. As companies grow older or become more profitable, they require less external financing and can rely on internally generated funds.

Considerations when acquiring financing

When it comes to equity financing for SMEs, the value of equity is very difficult to be ascertained. During the pitch 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 fund is to be spent, its projected returns, and a clear repayment plan. The repayment plan should match the cash flows available after all current expenditure but before dividend payments. On another note, SMEs need to understand the importance of credit and improve the financial and accounting qualities of the company, as well as strengthening their credit construction with honesty and integrity as the basis.

To optimise the development and operations of the business, SME owners need to manage their capital structure, which is the composition of debt and equity capital, including the proportion of short and long-term loans within the debt capital. SME owners should first identify the total funds required based on the purpose of financing, then optimise their capital structure by comparing the costs against the benefits of using debt and equity financing. Taking into account different financing channels and liquidity requirements, SME owners can utilise a mix of debt (short and long-term) and equity best suited for the business. In addition, SME owners can also utilise other sources of financing, such as trade credit, leasing and grants into the mix if applicable.

In sum, before seeking the influx of capital, SME owners must be absolutely certain that the money is essential to achieve the goals of the business. It is important to weigh the pros and cons of both debt and equity financing to decide on what is best for the business, but the difficult part comes after securing funds, where owners should think long-term by using funds for the right purposes and motivate employees to be committed to work harder than ever before. After all, what is working capital without the little extra work?

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


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