Question

How does a company utilize stocks and bonds in financing growth? Identify the major sources of external financing for companies.

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Answer 1

A company needs financing for continuing its business operations as well as making capital investments for fuelling growth. A company uses both equity and debt to finance its business.

Any growth which might come from increasing market share or making capital investment requires source of financing. Equity might be public or private depending on whether the company's stocks are traded on an exchange or not. On the other hand, debt might be in the form of bank loans and bonds or commercial paper issuance. A company maintains a desirable debt-to-equity or the leverage ratio in order to minimize the cost of capital and hence increase the firm's value.

Major sources of external financing:

Equity capital

Equity capital is raised by issuing equity shares, which are subscribed by investors. This capital, in the initial stages, usually comes from promotors. Once the company decides to go for public or private placement, investors subscribe to these shares in the hopes of receiving dividends and capital appreciation.

Preferred stock

Similar to equity capital, investors subscribe to preferred stock. These shares-holders have a higher right in case of liquidation than common equity shares and receives a dividend higher than the common equity shareholders.

Debentures/Bonds

A company issues debentures and bonds to raise debt money from the market participants. This option for the company is usually cheaper as debt has usually a cost lower than equity since the company doesn't have to share ownership rights. Market participants demand a yield on the bonds which depends on the risk profile of the company and the market interest rates.

Term loan

This is the most common source of debt financing in which a company approaches a bank or financial institution for raising debt. Unlike a debenture or a bond, a term loan is usually not traded in the market. This term loan is back by some collateral by the company. The cost of term loan depends on the bank's or financial institution's assessment of the bank's financial statement, management quality and repaying capacity.

Venture capital

Companies in the start-up phase seek venture capital financing. Venture capitalists critically investigate a company and its growth prospects to make a decision whether to invest or not.

Short-term loan

Short-term loans are offered by banks and financial institutions generally to finance the day to day or inventory needs of the company.

Bank overdraft

Short-term credit provided by banks to finance the day to day activities. Unlike a short-term loan, overdraft facilities are generally used to fulfill the requirement due to time-gap between collections and payments.

Trade credit

This is a source of short term financing, which is generally given by the creditors of the company which allows the company to delay its payment for some specified time.