To grow their businesses into new markets or areas, corporations frequently need to acquire external finance or funding. They can use it to ward off rivals or invest in research and development (R&D). And while companies do strive to finance these investments with revenues from current business operations, it is frequently preferable to turn to outside lenders or investors.
Even though millions of companies worldwide are spread across many different industries, only a few funding sources are open to all companies. Retained earnings, debt, and equity capital are some of the best places to look for funding.
In this article, we’ll examine these three sources of capital and what they mean for businesses.
What are sources of funding available for companies?
To expand their business, companies look for funding sources. Providing resources for a program, project, or necessity is often referred to as funding. Financing can start for both short-term and long-term goals. The funding sources for small businesses or start-ups include;
- Retained earnings
- Debt capital
- Equity capital
- Retained Earnings
Companies typically exist to generate a profit by offering goods or services at a price higher than what it costs to manufacture them. This is the most fundamental source of funding for any business and, ideally, the primary way that the organization generates revenue. Retained earnings (RE) is the net income available after meeting costs and commitments.
Because the corporation retains retained earnings rather than paying dividends to shareholders, retained earnings are significant. Retained earnings rise when companies make more money, enabling them to draw from a larger pool of capital. Retained earnings decline when dividend payments to shareholders increase.
Pros
Retained earnings are the funding sources for small businesses and grow the company. For firms, retained earnings have many benefits, and this is why:
- Businesses have no debt to anyone using retained earnings.
- They are a cheap source of funding. The opportunity cost is the cost of capital when employing retained earnings. By withholding dividends, firms force shareholders to forfeit this. They save money when using retained earnings.
- Corporate management can determine whether to distribute all or a portion of the company's profits to shareholders. The management group can then select how to use funds that would reinvest in the company.
- They dilute no ownership.
Cons
However, there are drawbacks to using retained revenues to support initiatives and promote business expansion. For illustration:
- Even with retained earnings invested in the business, shareholders' value is still subject to loss, and this is due to the possibility that they won't produce higher profits.
- Another claim is that employing retained earnings is inefficient since they don't genuinely belong to the company, and they belong to the shareholders.
- Debt Capital
Like individuals, companies can borrow money, and they frequently do. Borrowing money to fund initiatives and promote growth is a widespread practice. Debt capital is helpful in a variety of situations for short-term requirements. Additionally, high-growth companies require a lot of capital quickly. Private borrowing can take the form of conventional loans from banks or other lenders, whereas public borrowing takes the form of debt issues.
Traditional loans and debt issues are two ways that debt capital is available. The term "corporate bonds" refers to debt issues, enabling many investors to become the company's debtors or lenders. Companies can approach banks, financial institutions, and lenders just like consumers to get the required capital.
Pros
- Tax deductions on interest payments to banks and other lenders are made possible by borrowing money.
- In comparison to other sources of funding, interest payments are often less expensive.
- It can raise company credit scores, especially for start-up businesses.
- Because of borrowing funds, distributing gains to investors is unnecessary.
Cons
But using debt capital also has some drawbacks.
- When borrowing money, paying principal and interest to the lenders or bondholders is the primary factor that can lead to a problem if profits are low.
- Unable to pay interest or principal payments can lead to a default or bankruptcy.
- Equity Capital
Selling ownership stakes by means of shares to buyers who become shareholders is one way for a business to raise money, known as equity capital. Private companies can raise money by selling stock holdings to family members and close friends or by going public through an IPO.
Public corporations can conduct secondary offerings if they need additional funds.
Pros
The advantage of this approach is:
- There is nothing to repay because investors, not creditors, are the source of this finance.
- It enables businesses with bad credit histories to raise capital.
Cons
Equity capital has several drawbacks, including:
- Dilution. The voting rights of equity shareholders also mean that if a firm sells more shares, some of its control is lost or diluted. This comprises start-ups and small enterprises that work with venture capitalists to raise money for their operations.
- Costs: Given that investors could anticipate a portion of the profits, equity capital is frequently among the most expensive types of funding.
- There are no tax advantages compared to those provided by debt capital.
- Obtaining outside funding may heighten anxiety since investors might not concur with management's predictions about the company's future.
Which is preferable, equity or debt financing?
Both equity and debt financing include some risk. Companies that use debt financing must pay back their creditors. Bankruptcy or default are possible outcomes of non-repayment, which may impact corporate credit scores. No tax advantages are associated with equity financing, even though corporations cannot pay off any debts using it. Because it includes new shareholders in the mix, there is also a risk of diluting ownership. Old and new investors can anticipate receiving a cut of corporate profits.
Other funding sources
Funding sources include venture capital, donations, private equity, grants, and subsidies that don’t have an immediate requirement on Return on Investment (ROI) except for venture capital and private equity. These funding sources are also known as “crowdfunding” or soft funding.
Bottom line
Consider the amount of money you need and the trade-offs you are willing to give up for funding. This will help you to choose the most effective way to raise capital to grow your company.
