Alabama A&M University S M A L L FA R M S R E S E A R C H C E N T E R FA C T S H E E T COLLEGE OF AGRICULTURAL, LIFE AND NATURAL SCIENCES United States Department of Agriculture Office of Advocacy and Outreach (OAO) Financing Alternatives - Debt Vs Equity If you are considering starting a new farming business, buying an existing one or expanding your own farm operation you will need to do some detailed business planning. An integral part of this plan should be your financial plan. Quite often the financial plan will require the owner (s) to seek outside sources of capital to implement their plans. This factsheet will look at two financing alternatives, equity financing and debt financing. Equity Financing Equity capital refers to money that you and any business associate(s) inject directly into the operation. If your operation is a sole proprietorship or a partnership, this type of financing would likely be in the form of an owner's contribution and would appear on the balance sheet as owner's equity. If your business is incorporated, anyone contributing equity capital would receive shares in the business. Equity capital results in some degree of ownership to those making the contribution. Debt Financing The most common alternative to equity financing is debt financing. This occurs when you make use of funds from a lender. The loan would be used for capital spending or for operating and would have to be repaid over a period of time. There would normally be a clear repayment schedule and rate of interest. Unlike equity financing no direct ownership rights would be associated with the financing, however there are usually some requirements to provide security by pledging (e.g. mortgaging) assets. The lender receives interest payments in exchange for risking his/her money. Financing Strategies Small Farms Research Center Alabama A&M University 4900 Meridian Street James I. Dawson Building RM #219 P.O. Box 700 Normal, AL 35762 How much debt and how much equity financing is appropriate and how will the mix affect your business? Why not use someone else's money for all your capital requirements? These are common questions to consider when assessing your financial plan. When a lender considers lending you money they will analyze your operation's financial situation, especially profitability, projected cash flows, and the health of your balance sheet. Things such as the debt to equity ratio and the debt repayment capacity affect the decision a lender makes when assessing a loan request. A prudent manager should also monitor the financial health of the business regularly and strive to maintain an appropriate mix of debt and equity. The greater the debt in relation to the equity (the debt/equity ratio) the greater the financial risk. The farm manager should always strive to keep the debt/equity ratio within the recommended range. _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 Equity financing allows the operation to consider further debt financing in the future, if needed. Increasing equity improves your operation's security in most cases. Some common sources of equity financing include your personal savings, or investments by relatives, friends, employees, or other business partners. Of course raising equity capital may mean you have to accommodate new decision-makers in your business, depending on the specific arrangements. Are you prepared to share some of your profit and/or independence in exchange for this infusion of capital? Will these investors have a say in how the farm is to be run or will they be passive partners? Will you see eye to eye on management decisions? If you feel comfortable with these issues you should seriously consider some form of equity financing the next time you need capital. Author: Duncan M. Chembezi, Ph.D. Professor and Director, Small Farms Research Center , Alabama A&M University Small Farms Research Center, Alabama A&M University 4900 Meridian Street James I. Dawson Building, Room 219 Normal, AL 35762 Small Farms Research Center Background. The Small Farms Research Center was developed to assist small farmers with limited resources in Alabama’s underserved communities. The center was first developed in 2000 to assist minorities, especially women, African Americans and underserved individuals improve their farm management practices, given ones condition and resources. The mission of the Center and the Small Farmers Outreach program is to assist all small and limited resources farms effectively deal with risk management and food safety issues and provide them with informational sessions. The Center has also expanded its outreach efforts to meet the needs of entrepreneurs and businessman. The center is located at Alabama A&M University in the Dawson Building. The center specializes in following areas Marketing and Business Plans -Record keeping and Loan Application -Identify alternative enterprises -Personal Management -Legal Issues -Finances -International Business and Procurement -Accounting Issues -Taxes -Business Development -Conducting seminars on Government programs and other issues For more information about us give us a call at (256) 372-4970 and 1-866858-4970. Website: www.aamu.edu/smallfarmers Cooperating Units: USDA Office of Advocacy and Outreach (OAO), USDA/NIFA/ Beginning Farmers and Ranchers Development Program (BFRDP), USDA/OAO/Outreach Assistance for Socially Disadvantaged Farmers and Ranchers (OASDFR) Program, Alabama Cooperative Extension Systems, and Alabama A&M University. 2