Corporations often need to raise external funding, or capital, in order to expand their businesses into new markets or locations, to invest in research & development, 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.
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.
- Companies need to raise capital in order to invest in new projects and grow.l
- There are ultimately just three main ways companies can raise capital: from net earnings from operations, by borrowing, or by issuing equity capital.
- Debt and equity capital are commonly obtained from external investors, and each comes with its own set of benefits and drawbacks for the firm.
What Sources Of Funding Are Available To Companies?
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 or RE.
These funds can be used to invest in projects and grow the business. but are often allocated instead to reward shareholders in the form of dividend payments or share buybacks. The reason for this is that it is often less expensive for the company to raise capital from external investors, and attracting more investors through these stockholder incentives can prove to be more cost effective overall.
2. Debt Capital
Like individuals, companies can and borrow money. This can be done privately through bank loans, or it can be done publicly through a debt issue. These debt issues are known as corporate bonds, which allows a wide number of investors to become lenders (or creditors) to the company.
The main consideration for borrowing money is that the principal and interest must be paid to the lenders. A failure to pay interest or repay the principal can result in default or bankruptcy. But, the interest paid on debt is typically tax-deductible for the company and those interest costs tend to be less expensive than other sources of capital.
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. The benefit of this method is that investors do not require making interest payments like bondholders do, and so this type of capital can be raised even when the first is not earning any money.
The main consideration then is that future profits are to be divided among all shareholders. Additionally, shareholders of equity have voting rights, which means that a company forfeits or dilutes some of its ownership control as it sells off more shares. Equity capital also tends to be among the most expensive forms of capital for a firm, and does not come with some of the tax benefits that debt does.
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, it is most important to 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.