There are several types of financing that households and firms can use. Basically, financing can be categorised into two types, namely debt financing and equity financing. The two types of financing have fundamental differences, both in terms of the status of the funds and the reward scheme for the use of these funds.
Debt Financing
Debt financing is a form of financing in which the party in need owes the fund owner, usually with interest as compensation. The debt financing, among others, is in the form of bonds and bank credit. With this financing, households and firms can fulfil their funding needs without inviting too much involvement of fund owners. The fund owners only need to be sure that the funds they lent are being used properly for the agreed purpose and that the households and firms can repay the debt and the interest at maturity. The interest rate is predetermined and generally fixed. Excess utility or profit above interest expense belongs to households and firms. Meanwhile, risk is borne by households and firms as borrowers.
Equity Financing
Equity financing is a form of financing in which the party in need receives capital participation from the fund owner, usually with a share on return as compensation. There are several types of equity financing, among others, in the form of bank financing, participation in a business, and stocks. In equity financing, the distribution of profit is arranged. In contrast to debt financing, in equity financing, funds are used for business so that their value may increase or decrease (along with the profit earned). In this regard, the funds invested are business capital. Equity financing is capital participation, so it is generally used by firms for business financing.