Businesses require capital in several forms and most typically, money for their smooth operation. Capital signifies anything valuable, providing a benefit, and often boils down to cash. Cash accessibility can determine company survival, expansion, and launching future projects. Hence, how do businesses raise capital necessary for their survival and what are their options?
Commercial entities can leverage two types of capital for their functioning: debt and equity. Debt capital, also known as debt financing, comprises borrowed funds, where companies agree to return the money to the lender on an agreed date. Common debt capital forms include loans and bonds utilized by businesses for expansion or launching new ventures. Typically, a business wishing to capitalize via debt will need a loan from a bank-making the bank the lender and the company the borrower.
However, debt capital also has its drawbacks, like the added charge of interest. This cost of accessing the capital is termed the cost of debt capital, which businesses need to pay to lenders regardless of their performance.
On the other hand, equity capital is not a borrowed money. They are funds generated through retained profits and the sale of company stocks. If incurring debt isn't feasible, companies can capitalize by selling additional stocks. Equity financing, unlike debt, doesn’t need to be repaid. But the cost of equity capital is the ROI shareholders expect based on the market performance. These returns are realized in the form of dividend payments and stock valuations.
It's worth noting that equity capital also has disadvantages. Selling more shares tends to dilute ownership-a cause of concern for founders against surrendering control. The cost of capital for preferred shares' sale is typically lower than common shares, largely due to The lower risk attached to preferred shares - a more secure claim on company assets. However, irrespective of these, equity capital types are generally costlier than debt capital since lenders are guaranteed payment by law.
Companies may avoid borrowing money for capital. They may be ourselves leveraged, having poor or no credit history. In such cases, companies turn to the market for raising funds. These include startups raising capital via angel investors and venture capitalists or private companies going public by issuing an IPO.
To summarize, companies can utilize two principal capital sources-debt or equity, considering their capital requirements, business profile, and financial conditions. While debt is often favored for not diluting ownership and being less expensive, borrowing is not always an option for all companies, especially amidst high-interest rates.