In: Finance
in 200 words or more, How does one understand the various sources of capital, including debt and equity financing?
A business can raise funds from various sources. Each of the
source has unique characteristics, which must be properly
understood so that the best available source of raising funds can
be identified. There is not a single best source of funds for all
organisations. Depending on the situation, purpose,
cost and associated risk, a choice may be made about the source to
be used. For example, if a business wants to raise funds for
meeting fixed capital requirements, long term funds may be required
which can be raised in the form of owned funds or borrowed funds.
Similarly, if the purpose is to meet the day-to-day requirements of
business, the short term sources may be tapped.
1. Retained Earnings
A company generally does not distribute all its earnings amongst the shareholders as dividends. A portion of the net earnings may be retained in the business for use in the future. This is known as retained earnings. It is a source of internal financing or selffinancing or ‘ploughing back of profits’. The profit available for ploughing back in an organisation depends on many factors like net profits, dividend policy and age of the organisation.
2. Issue of Shares(equity financing)
The capital obtained by issue of shares is known as share capital. The capital of a company is divided into small units called shares. Each share has its nominal value. For example, a company can issue 1,00,000 shares of Rs. 10 each for a total value of Rs. 10,00,000. The person holding the share is known as shareholder. There are two types of shares normally issued by a company. These are equity shares and preference shares. The money raised by issue of equity shares is called equity share capital, while the money raised by issue of preference shares is called preference share capital.
(a) Equity Shares
Equity shares is the most important source of raising long term capital by a company. Equity shares represent the ownership of a company and thus the capital raised by issue of such shares is known as ownership capital or owner’s funds. Equity share capital is a prerequisite to the creation of a company. Equity shareholders do not get a fixed
dividend but are paid on the basis of earnings by the company. They are referred to as ‘residual owners’ since they receive what is left after all other claims on the company’s income and assets have been settled. They enjoy the reward as well as bear the risk of ownership. Their liability, however, is limited to the extent of capital contributed by them in the company. Further, through their right to vote, these shareholders have a right to participate in the management of the company.
(b) Preference Shares
The capital raised by issue of preference shares is called preference share capital. The preference shareholders enjoy a preferential position over equity shareholders in two ways:
(i) receiving a fixed rate of dividend, out of the net profits
of the company, before any dividend is declared for equity
shareholders;
and
(ii) receiving their capital after the claims of the company’s creditors have been settled, at the time of liquidation. In other words, as compared to the equity shareholders, the preference shareholders have a preferential claim over dividend and repayment of capital. Preference shares resemble debentures as they bear fixed rate of return. Also as the dividend is payable only at the discretion of the directors and only out of profit after tax, to that extent, these resemble equity shares. Thus, preference shares have some characteristics of both equity shares and debentures. Preference shareholders generally do not enjoy any voting rights.
3. Debentures(Debt financing)
Debentures are an important instrument for raising long term debt capital. A company can raise funds through issue of debentures, which bear a fixed rate of interest. The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay at a future date. Debenture holders are, therefore, termed as creditors of the company. Debenture holders are paid a fixed stated amount of interest at specified intervals say six months or one year.