For businesses to grow, they need to make investments. These can be financed either by reinvesting the business's own funds, or by raising external capital. But how should you think as an entrepreneur when faced with the choice of whether to finance an investment with equity or external financing?

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Equity capital

Equity is the difference between a company's assets and liabilities. When a company generates profits, its equity increases. For the company to continue to grow and hopefully generate higher profits in the future, it is often a natural choice to reinvest all or part of the profits in the business. This can be done by the company making investments, paying off debt or increasing cash to improve liquidity. Using equity and current income is the most common way of financing investments among Swedish entrepreneurs.

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External funding

Access to capital is a prerequisite for businesses to grow. However, for many small and growing businesses, their own capital is not enough to invest and they need to rely on external capital to finance their investments. There are several different forms of external financing, but for most, business loans are the most common way to finance investments.

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Investing with equity or external financing?

Whether it is best to invest with equity or with the help of external financing can differ from company to company and from investment to investment. It is therefore important to have an understanding of how they differ, how they affect key performance indicators in the company and when the investment is expected to pay off. This will enable you to choose the financing that will allow your company to get the maximum return on investment.

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Solidity

When you invest, your company's equity ratio will increase or decrease differently depending on whether you reinvest the equity or use external financing. The equity ratio is a measure of the proportion of assets financed by equity and is used to describe the long-term solvency of a company. When equity is reinvested in the company, the equity ratio will increase and, correspondingly, it will decrease if investments are made with external financing.

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When investing, it is therefore a good idea to look at the equity ratio of your company. If your company has a low equity ratio, investing using your own capital is preferable. This is partly because the equity ratio will increase and partly because the company's own money may generate a better return than if it were just sitting in the company's account. However, investing with equity is relatively expensive compared to, for example, a business loan, as most entrepreneurs want to generate a higher percentage return than the interest rate that the loan has. If the company has a high equity ratio, it is therefore preferable to finance the investment with external funding.

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Type of investment

The type of investment you intend to make can also have an impact on which financing may be preferable. As mentioned above, reinvesting profits in the company is an important part of healthy entrepreneurship, but a relatively expensive way to finance investments. Investing with your company's own capital also means drawing on your liquid assets, which affects your company's short-term solvency. Therefore, if the investment is made in an asset that can be quickly realized and generate income for the company, equity can be a good way to finance the investment. However, if the investment is made in an asset that will be used over a longer period of time, it is usually better to finance it with external capital. This way you avoid risking the liquidity of the company and thus the short-term solvency. However, it is not only the ability to pay the company's debts that affects liquidity and the type of financing you should choose. Almost all businesses are run for profit and with the aim of generating a return for the owner. Therefore, if your business has both good solvency and liquidity, financing with a business loan, for example, can allow you to both drive growth in the company, while you, as the owner, can use some of the liquid funds to distribute some of the profits to yourself and get a return for your work.

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Invest in time

Another aspect to consider is when the investment needs to be made. Most Swedish companies are restrictive when it comes to debt and choose to use their own capital and save for investments, which is not optimal. If companies save for investments, there is a risk that the investment will be made too late and thus not have the desired effect. When you wait to invest, you also miss out on the expected return while the investment is pending. This means not only that you as an owner miss out on increased profits and potential dividends, but also that the growth of the company is impaired as the return could have been reinvested in the meantime.