Corporations often need to raise external funding or capital in order to expand their businesses into new markets or locations. It also allows them to invest in research & development (R&D) or to fend off the competition. And, while companies do aim to use the profits from ongoing business operations to fund such projects, it is often more favorable to seek external lenders or investors to do so. Despite all the differences among the thousands of companies in the world across various industry sectors, there are only a few sources of funds available to all firms. Some of the best places to look for funding are retained earnings, debt capital, and equity capital. In this article, we examine each of these sources of capital and what they mean for corporations.
Companies generally exist to earn a profit by selling a product or service for more than it costs to produce. This is the most basic source of funds for any company and, hopefully, the primary method that brings in money to the firm. The net income left over after expenses and obligations is known as retained earnings (RE).
Retained earnings are important because they are kept by the company rather than being paid out to shareholders as dividends. Retained earnings increase when companies earn more, which allows them to tap into a higher pool of capital. When companies pay more to shareholders, retained earnings drop. These funds can be used to invest in projects and grow the business. Retained earnings provide several advantages for businesses. Here's why:
But there are cons to using retained earnings to fund projects and fuel corporate growth. For instance:
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Companies can borrow money just like individuals—and they do. Using borrowed capital to fund projects and fuel growth isn't uncommon. There are several instances when debt capital comes in handy. for short-term needs. And businesses that are deemed high-growth need a lot of capital and they need it fast. Borrowing money can be done privately through traditional loans through a bank or other lender, or publicly through a debt issue. Debt capital comes in the form of traditional loans and debt issues. Debt issues are known as corporate bonds. They allow a wide number of investors to become lenders or creditors to the company. Just like consumers, companies can reach out to banks, other financial institutions, and other lenders to access the capital they need. This gives them a leg up because:
But there are downfalls to using debt capital. For instance:
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It may be harder for smaller or troubled businesses to get debt financing when the economy is going through a slowdown. A company can raise capital by selling off ownership stakes in the form of shares to investors who become stockholders. This is known as equity funding. Private corporations can raise capital by offering equity stakes to family and friends or by going public through an initial public offering (IPO). Public companies can make secondary offerings if they need to raise more capital. The benefit of this method is:
Disadvantages of equity capital include:
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One of the main ways that companies can raise money internally is through retained earnings. This is the simplest and easiest way to do so. Retained earnings is a generalized term that refers to any net income that remains after any expenses and obligations are paid off.
The three major sources of corporate financing are retained earnings, debt capital, and equity capital. Retained earnings refer to any net income remaining after a company pays off any expenses and obligations. Debt capital is funding that a company raises by borrowing money from lenders through loans or corporate bond offerings. Equity capital is cash that a public company raises or earns by issuing new shares to shareholders on the market. This could be done by selling common or preferred stock.
Both debt and equity financing can be risky. Debt financing obligates companies to repay creditors. Failure to repay can result in default or bankruptcy. This can affect corporate credit scores. While companies aren't obligated to repay any debts with it, there are no tax benefits associated with equity financing. There's also a risk of dilution of ownership since it involves adding more shareholders to the mix. Investors (new and old) may also expect a share of corporate profits. In an ideal world, a company would simply obtain all of the money it needed to grow simply by selling goods and services for a profit. But, as the old saying goes, "you have to spend money to make money," and just about every company has to raise funds at some point to develop products and expand into new markets. When evaluating companies, look at the balance of the major sources of funding. For example, too much debt can get a company into trouble. On the other hand, a company might be missing growth prospects if it doesn't use money it can borrow. Financial analysts and investors often compute the weighted average cost of capital (WACC) to figure out how much a company is paying on its combined sources of financing. |