It’s not a secret that running a business requires a great deal of capital. The first that comes to our minds while hearing the term “financial capital” is money. Assets, securities, and cash express financial capital. Corporate companies are constantly trying to raise capital. But the question is, how?
Notably, a business can use two types of capital to fund operations: debt and equity. Prudent corporate finance practice includes determining the mix of debt and equity that is most cost-effective. Let’s explore both of them in the following essay.
Debt Capital
Funding using debt capital occurs when a business borrows money and agrees to return it to the lender later. Remarkably, the most well-known types of dept capital companies use are loans and bonds. The big companies use those to fuel their expansion plans or to fund new projects. In comparison, small companies often use credit cards to raise their capital.
A company that wants to raise capital through debt usually goes to the bank for a loan. Therefore, the bank becomes the lender, while the company becomes the debtor. The bank charges interest, which should be noted on its balance sheet.
Furthermore, the companies often use corporate bonds. These bonds are traded to investors in exchange for money and mature after a certain date. Corporate bonds are very risky as the chances of default are higher than bonds issued by the government. Moreover, they pay a much higher yield.
However, it’s essential to determine risks in advance. Some rating agencies, such as Standard and Poor’s, are responsible for rating corporate debt quality. Notably, agencies signal to investors how dangerous the bonds are.
Moreover, it is worth noting that debt capital has disadvantages, too, with the additional burden of interest. This expense is the cost of debt capital. There should be Interest payments to lenders despite business performance. A highly-leveraged business may have debt payments that surpass its revenue during a bad economy.
Equity Capital
Equity Capital is generated by selling shares of company stocks; therefore, a company can raise capital. These can be common shares or preferred shares.
Common stocks are shares of ownership in a corporation that provide their holders voting rights. However, their ownership isn’t a priority as other shareholders are. Significantly, if the company liquates, first they pay other creditors and shareholders.
Shareholders who own preferred stocks get dividend payments before shareholders of common stocks; still, preferred stocks do not have voting rights.
The advantage of raising equity capital is that the business is not required to pay back shareholder investment. Meanwhile, the disadvantage is that each shareholder owns a small piece of the business. Hence, ownership becomes diluted. Company owners must ensure the company remains profitable to maintain an elevated stock valuation.
As preferred shareholders have a higher claim on company assets, preferred shareholders’ risk is lower than to common shareholders. Consequently, the cost of capital for the sale of preferred shares is lower than for common shares. Both equity capital types are more expensive than debt capital as lenders always have guarantee of payment by law.
As we already mentioned, some businesses choose not to borrow more money to raise their capital. Maybe because they’re already leveraged and can’t take on any more liability. This kind of companies may turn to the market in order to get some cash.
A startup company can raise capital through angel investors and venture capitalists. Private businesses may decide to go public by issuing an initial public offering. Issuing stock on the primary market performs this. After it, shares are traded on the secondary market by investors.
