Studying the Sources of Business Capital
Every business needs sources of capital (financial backing), because it's capital that provides the money for the assets a business needs to carry on its operations. Common examples of business assets include the following:
The working cash balance a business needs for day-to-day activities
Products held in inventory for sale
Long-life operating assets (buildings, machines, computers, office equipment, and so on)
Where does a business get capital? Regardless of the particular legal structure a business uses, the answer comes down to two basic sources: debt and equity.
Debt refers to the money borrowed by a business
Equity refers to money invested in the business by owners
Making profit also provides equity capital. No matter which type of business entity form that it uses, every business needs a foundation of ownership (equity) capital to persuade people to loan money to the business.
Deciding on debt
Suppose a business has $10 million in total assets. How much of the $10 million should be supplied by debt capital? As you probably know, there’s no simple answer to such a question. Some businesses depend on debt capital for more than half of the money needed for their assets.
In contrast, some businesses have virtually no debt at all. You find many examples of both public and private companies that have no borrowed money. But as a general rule, businesses carry some debt (and therefore have interest expense). The debt decision is the responsibility of the chief financial officer and chief executive of the business.
Most businesses borrow money because their owners are not able or not willing to supply all the capital needed for its assets. As you know, banks are one major source of loans to businesses. Of course, banks charge interest on the loans; a business and its bank negotiate an interest rate acceptable to both. Many other terms and conditions are negotiated, including the term (time period) of the loan and whether collateral is required.
The loan contract between a business and its lender may prohibit the business from distributing profit to owners during the period of the loan. Or, the loan agreement may require that the business maintain a minimum cash balance. Generally speaking, the higher the ratio of debt to equity, the more likely a lender will charge higher interest rates and will insist on tougher conditions, because the lender has higher risk that the business might default on the loan.
The president or other appropriate financial officer of the business signs the note payable to the bank. In addition, the bank (or other lender) may ask the major investors in a smaller, privately owned business to sign the note payable as individuals, in their personal capacities — and it may ask their spouses to sign the note payable as well.
You should definitely understand your personal obligations if you are inclined to sign a note payable of a business. You take the risk that you may have to pay some part or perhaps the entire amount of the loan from your personal assets.
Tapping two sources of owners’ equity
When owners invest money in a business, the accountant records the amount of money as an increase in the company’s cash account. And, to keep things in balance, the amount invested in the business is also recorded as an increase in an owners’ equity account. Owners’ equity also increases when a business makes profit.
Because of the two different reasons for increases, and because of certain legal requirements regarding minimum owners’ capital amounts that have to be maintained by a business for the protection of creditors, the owners’ equity of a business is divided into two separate types of accounts:
Invested capital: This type of owners’ equity account records the amounts of money that owners have invested in the business, which could have been many years ago.
Retained earnings: The profit earned by a business over the years that has been retained and not distributed to its owners is accumulated in this account. If all profit had been distributed every year, retained earnings would have a zero balance.
Whether to retain part or all of annual net income is one of the most important decisions that a business makes; distributions from profit have to be decided at the highest level of a business. A growing business needs additional capital for expanding its assets, and increasing the debt load of the business usually cannot supply all the additional capital.
So, the business plows back some of its profit for the year rather than giving it out to the owners. In the long run this may be the best course of action because it provides additional capital for growth.