Companies always seek sources of funding to grow the business. Funding, also called financing, represents an act of contributing resources to finance a program, project, or a need. Funding can be initiated for either short-term or long-term purposes. The different sources of funding include:
- Retained earnings
- Debt capital
- Equity capital
Summary
- The main sources of funding are retained earnings, debt capital, and equity capital.
- Companies use retained earnings from business operations to expand or distribute dividends to their shareholders.
- Businesses raise funds by borrowing debt privately from a bank or by going public (issuing debt securities).
- Companies obtain equity funding by exchanging ownership rights for cash coming from equity investors.
Retained Earnings
Businesses aim to maximize profits by selling a product or rendering service for a price higher than what it costs them to produce the goods. It is the most primitive source of funding for any company.
After generating profits, a company decides what to do with the earned capital and how to allocate it efficiently. The retained earnings can be distributed to shareholders as dividends Dividend A dividend is a share of profits and retained earnings that a company pays out to its shareholders. When a company generates a profit and accumulates retained earnings, those earnings can be either reinvested in the business or paid out to shareholders as a dividend. , or the company can reduce the number of shares outstanding by initiating a stock repurchase campaign.
Alternatively, the company can invest the money into a new project, say, building a new factory, or partnering with other companies to create a joint venture.
Debt Capital
Companies obtain debt financing privately through bank loans. They can also source new funds by issuing debt to the public.
In debt financing, the issuer (borrower) issues debt securities, such as corporate bonds or promissory notes. Debt issues also include debentures Debenture A Debenture is an unsecured debt or bonds that repay a specified amount of money plus interest to the bondholders at maturity. A debenture is a long-term debt instrument issued by corporations and governments to secure fresh funds or capital. Coupons or interest rates are offered as compensation to the lender. , leases, and mortgages.
Companies that initiate debt issues are borrowers because they exchange securities for cash needed to perform certain activities. The companies will be then repaying the debt (principal and interest) according to the specified debt repayment schedule and contracts underlying the issued debt securities.
The drawback of borrowing money through debt is that borrowers need to make interest payments, as well as principal repayments, on time. Failure to do so may lead the borrower to default or bankruptcy.
Equity Capital
Companies can raise funds from the public in exchange for a proportionate ownership stake in the company in the form of shares issued to investors who become shareholders after purchasing the shares.
Alternatively, private equity financing can be an option, provided there are entities or individuals in the company’s or directors’ network ready to invest in a project or wherever the money is needed for.
Compared to debt capital funding, equity funding does not require making interest payments Interest Expense Interest expense arises out of a company that finances through debt or capital leases. Interest is found in the income statement, but can also be calculated through the debt schedule. The schedule should outline all the major pieces of debt a company has on its balance sheet, and calculate interest by multiplying the to a borrower.
However, one disadvantage of equity capital funding is sharing profits among all shareholders in the long term. More importantly, shareholders dilute a company’s ownership control as long as it sells more shares.
Other Funding Sources
Funding sources also include private equity, venture capital, donations, grants, and subsidies that do not have a direct requirement for return on investment (ROI), except for private equity and venture capital Venture Capital Venture capital is a form of financing that provides funds to early stage, emerging companies with high growth potential, in exchange for equity or an ownership stake. Venture capitalists take the risk of investing in startup companies, with the hope that they will earn significant returns when the companies become a success. . They are also called “crowdfunding” or “soft funding.”
Crowdfunding represents a process of raising funds to fulfill a certain project or undertake a venture by obtaining small amounts of money from a large number of individuals. The crowdfunding process usually takes place online.
Related Readings
Finance is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ FMVA® Certification Join 350,600+ students who work for companies like Amazon, J.P. Morgan, and Ferrari certification program, designed to transform anyone into a world-class financial analyst.
In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:
- Cash Flow from Financing Activities Cash Flow from Financing Activities Cash Flow from Financing Activities is the net amount of funding a company generates in a given time period, used to finance its business. Finance activities include the issuance and repayment of equity, payment of dividends, issuance and repayment of debt, and capital lease obligations
- Debt vs Equity Financing Debt vs Equity Financing Debt vs Equity Financing - which is best for your business and why? The simple answer is that it depends. The equity versus debt decision relies on a large number of factors such as the current economic climate, the business' existing capital structure, and the business' life cycle stage, to name a few.
- Revenue-Based Financing Revenue-Based Financing Revenue-based financing, also known as royalty-based financing, is a type of capital-raising method in which investors agree to provide capital to a company in exchange for a certain percentage of the company’s ongoing total gross revenues.
- Top Banks in the USA Top Banks in the USA According to the US Federal Deposit Insurance Corporation, there were 6,799 FDIC-insured commercial banks in the USA as of February 2014. The country's central bank is the Federal Reserve Bank, which came into existence after the passage of the Federal Reserve Act in 1913