3.06 – Financing Your Business: Sources of Cash & Capital
Financing a Business: Sources of Cash and Capital
Running a business requires financial backing, known as capital, which can come from two primary sources: debt and equity. Debt involves borrowed money, either secured (like a bank loan) or unsecured (like vendor credit terms). Equity includes capital invested by owners or investors and retained profits.
To understand how businesses finance their assets, let’s consider an example. A business with total assets of $27.172 million at fiscal year-end 2020 generated three liabilities from its profit-making activities: accounts payable, accrued expenses payable, and other current liabilities. These three liabilities contributed $3.963 million to the total assets. Debt provided $7.250 million, and owners’ equity accounted for $15.959 million, summing up to match the total assets.
Understanding Liabilities
Spontaneous Liabilities
These short-term, non-interest-bearing liabilities arise directly from a business’s expense activities. They include accounts payable, accrued expenses payable, and income tax payable. These liabilities occur naturally as businesses buy on credit or delay payment of certain expenses.
Debt and Equity Mix
Deciding the mix of debt (interest-bearing liabilities) and equity (invested owners’ capital and retained earnings) requires careful consideration. There’s no one-size-fits-all answer. The example business has a significant amount of debt relative to its owners’ equity, which might make some business owners uneasy.
Advantages of Debt
Access to Capital
Many businesses cannot raise all the necessary capital from equity alone, making debt a crucial additional source.
Lower Interest Rates
Lenders typically charge lower interest rates compared to the expected returns on owners’ equity. For example, a business might pay 6% annual interest on debt but aim for a 12% return on equity.
Disadvantages of Debt
Fixed Interest Payments
Businesses must pay interest even during periods of loss or when returns on assets are low.
Repayment Pressure
Debt must be repaid on the due date, which can pressure the business to generate sufficient funds. While businesses can sometimes roll over debt, lenders can demand full repayment.
Risks of Defaulting on Debt
Defaulting on debt contracts—failing to pay interest or repay debt on time—can have severe consequences. In extreme cases, lenders can force the business to shut down and liquidate assets to repay the debt. Bankruptcy, while an option to resolve financial crises, is a complex and damaging process that can severely cripple a business.
Equity Financing
Equity financing involves raising capital through selling ownership stakes in the business. This method does not require repayment like debt but does dilute ownership among shareholders. Retained earnings, or profits reinvested back into the business, also increase owners’ equity without diluting ownership.
