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 (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.
Key Takeaways
- Companies need to raise capital in order to invest in new projects and grow.
- Retained earnings, debt capital, and equity capital are three ways companies can raise capital.
- Using retained earnings means companies don't owe anything but shareholders may expect an increase in profits.
- Companies raise debt capital by borrowing from lenders and by issuing corporate debt in the form of bonds.
- Equity capital, which comes from external investors, costs nothing but has no tax benefits.
1. Retained Earnings
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:
- Using retained earnings means companies don't owe anyone anything.
- They are an inexpensive form of financing. The cost of capital of using retained earnings is what's called the opportunity cost. This is what companies make shareholders give up by not getting dividends. And corporations save on using retained earnings compared to issuing bonds because they aren't obligated to pay interest to bondholders.
- Corporate management can decide to use all or part of the company's earnings to pass on to shareholders. The leadership team can then decide how to use whatever funds to be reinvested back into the company.
- They do not dilute ownership.
But there are cons to using retained earnings to fund projects and fuel corporate growth. For instance:
- Shareholders can lose value even with retained earnings that are reinvested back into the company. That's because there's a chance they won't result in higher profits.
- There is also the argument that using retained earnings is not cost-effective because they don't actually belong to the company. Instead, they belong to shareholders.
Pros
Don't owe anyone anything
Inexpensive form of financing
Flexibility to use retained earnings as management desires
Do not dilute ownership
Cons
Loss of value for shareholders
Earnings actually belong to shareholders
2. Debt Capital
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:
- Borrowing money allows a tax deduction on any interest payments made to banks and other lenders.
- Interest costs tend to be less expensive than other sources of capital.
- It can help boost corporate credit scores, which is especially beneficial for new companies.
- Because the funds are borrowed, there is no need to share profits with investors.
But there are downfalls to using debt capital. For instance:
- The main consideration for borrowing money is that the principal and interest must be paid to the lenders or bondholders. This may be problematic when profits are scarce.
- A failure to pay interest or repay the principal can result in default or bankruptcy.
Pros
Interest on financing is tax deductible
Interest costs less than other sources of capital
Helps boost credit score
Profit-sharing isn't necessary
Cons
Companies are obligated to repay lenders
Failure to repay can result in default or bankruptcy
It may be harder for smaller or troubled businesses to get debt financing when the economy is going through a slowdown.
3. Equity Capital
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:
- There's nothing to repay. That's because this type of financing relies on investors—not creditors.
- It allows companies with poor credit histories to raise money.
Disadvantages of equity capital include:
- Dilution. Equity shareholders also have voting rights, which means that a company forfeits or dilutes some of its control as it sells off more shares. This includes small businesses and startups that bring in venture capitalists to help fund their companies.
- Costs. Equity capital tends to be among the most expensive forms of capital as investors may expect a share in profit.
- There are no tax benefits like the ones offered by debt financing.
- Internal headaches. Bringing in outside financing can lead to increased tension as investors may not agree with management's views of where the company is heading.
Pros
No repayment
Don't need a good credit history
Cons
Dilution in ownership
Investors expect share of profits
No tax benefits
Possibility of tension between investors and management
How Can Businesses Raise Money From Internal Sources?
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.
What Are the Three Major Sources of Financing?
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.
Is Debt Financing or Equity Financing Better?
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.
The Bottom Line
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.
