What Are the Sources of Funding Available for Companies?

Corporations often need to raise external funding or capital in order to expand their businesses into new markets or locations. Raising capital 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.

Companies, regardless of their industry sector, size, location, and so on, generally only have a few sources of funding available. 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.

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.

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 make more profit, giving them access to a higher pool of capital. Conversely, they decrease when companies lose money or opt to pay more to shareholders.

Advantages of Using Retained Earnings

The profits a company is left with can be used to invest in projects and grow the business. Here are some of the advantages of using retained earnings as a source of funding.

• Cheaper: Using retained earnings means companies don’t owe anyone anything. When they take on debt or issue new shares, there are transaction costs or interest payments, essentially making the funds more expensive to access.
• Increased shareholder value: Investing profits back into the business can fuel further growth in the future, boosting profits and the share price and paving the way for better or more attractive dividend payments.
• Financial safety net: Using retained earnings means being self-sufficient. Less debt and a healthier balance sheet are signs of a well-run business, which can help boost the share price and give the company a greater financial cushion to navigate challenging periods such as economic downturns.
• No dilution of ownership: Another alternative to using retained earnings is raising capital by selling shares. Equity financing isn’t always a popular option as issuing new shares decreases the equity ownership of current shareholders.

Disadvantages of Using Retained Earnings

There are also cons to using retained earnings to fund projects and fuel corporate growth. Notable drawbacks include:

• Opportunity cost: Despite how it might seem, retained earnings are not without cost. There is the opportunity cost, which is what companies make shareholders give up by not getting dividends, and the potential of not putting the money to work in the best possible way. Investing retained earnings back into the business doesn’t guarantee success. The funds may be invested poorly.
• Less income for shareholders: A large chunk of investors specifically look to invest in stocks that pay a decent dividend. Prioritizing spending earnings on investment over dividend payments can prove unpopular, particularly if the company was previously identified as an income stock.
• Lower returns: Retained earnings can be a drag on returns, at least in the short term. Dividends create an immediate return for shareholders, whereas reinvesting profits takes time to pay off.
• Limited capital: There may not be enough retained earnings to fund major growth projects. In some cases, issuing new shares or taking on debt is necessary to raise enough funds so that the company can fully chase its growth objectives.

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 from a bank or other lender, or publicly through a debt issue. Debt issues are known as corporate bonds. They allow a wide number of investors to become lenders or creditors to the company.

Advantages of Debt Capital

Securing capital from banks and other financial institutions or investors via bonds can carry numerous advantages. Notable benefits include:

• Tax deduction on interest: Borrowing money allows a tax deduction on any interest payments made to banks and other lenders.
• Lower interest costs: Interest costs can be less expensive than other sources of capital.
• Credit score boost: Can help boost corporate credit scores, which is especially beneficial for new companies.
• No profit-sharing: Because the funds are borrowed, there is no need to share profits with investors.
• Company ownership preserved: Securing funds through debt rather than equity preserves company ownership.

Disadvantages of Debt Capital

The downfalls of using debt capital, on the other hand, include:

• Potential for default: The business needs to generate enough regular income to pay the principal and interest on the debt when it comes due. Failure to do this can result in default or bankruptcy.
• Collateral may be required: Many lenders require companies to offer assets as collateral for loans. This means potentially losing important assets that are critical to the running of the business.
• Credit score may be too low: Debt financing is dependent on having a decent credit score and may not be an option open to all companies.

3. Equity Capital

A company can raise capital by selling off ownership stakes in the form of shares to investors. 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 in need of extra capital, meanwhile, can choose secondary equity financing options, such as a rights offering. This is essentially an invitation to existing shareholders to buy additional new shares in the company.

Advantages of Equity Financing

The main benefits of equity financing are:

• No need to pay it back: The money does not have to be repaid.
• Good credit history not required: Gives new companies or companies with poor credit histories that may struggle to get a traditional loan a way to raise capital.
• Benefits from new investors: New investors can bring useful expertise and contacts to help the business grow and reach its potential.

Disadvantages of Equity Financing

Disadvantages of equity capital include:

• Ownership 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.
• Investors expect to share in profits: Equity capital tends to be among the most expensive forms of capital as investors may expect a share in profit.
• No tax benefits: 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.
• Investor disapproval. Investors generally don’t like rights offerings. They don’t want to be asked to stump up more cash and would prefer the company to find alternative funding methods.

The Bottom Line

In an ideal world, a company would obtain all of the money it needed to grow simply by selling goods and services for a profit. However, 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/or expand into new markets.

When evaluating companies, look at the balance of the major sources of their 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.