Businesses and entrepreneurs face many challenges in the complex business environment. One of the biggest challenges is to raise external funding, or capital funding, 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 exist to make 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 method that brings in the most money, and is known as retained earnings. These funds can be used to reward shareholders in the form of dividend payments or share buybacks, but are also used to invest in projects and grow the business.
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 drawback of borrowing money is the interest that must be paid to the lender, where 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 and costs less than other sources of capital.
A company can generate money by selling part of itself in the form of shares to investors, which is known as equity funding. The benefit of this is that investors do not require interest payments as bondholders do. The drawback is that further profits are divided among all shareholders. Furthermore, shareholders of equity have voting rights, which means that a company forfeits or dilutes some of its own control as it sells off more shares.
In an ideal world, a company would bring in all of its cash 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 the 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.