All businesses need funds to grow and expand, such as for foraying in new markets, adding to research and development, and more. Whenever a business needs funds, it can either resort to an external source or internal sources. The internal source is primarily the profits that have been retained by the company over the years. And the external sources are resorting to debt and equity. Here, we will be discussing the sources and uses of funds, as well as the pros and cons of each source of funds.
Source of Funds
There are primarily three sources of funds available to the companies, and these are:
Retained earnings, as the word suggests, represent the earnings that a company retains. Or, it is the earnings that a company does not distribute among the shareholders through dividends. This is among the oldest and most secure, as well as a reliable source of funds. It is because the company here uses its own funds, and this makes it a less expensive source of finance.
Another benefit of this source is that the company does not have to depend upon any third party. And, it is a quick source of finance since the funds are with the company, and thus, it can use it anytime it wants. One more benefit is that here the company need not provide any security as may be required in case of borrowing money.
There are a few drawbacks of this source. First and foremost, the company conserves it by not paying dividends to the shareholders. This definitely impacts the investor’s confidence. Or it may pay a nominal dividend, lesser than the competitors, and thus the dividend yield drops substantially. Again, this is a point of concern for the investor and the company. Because share price valuation will go down and the company may have difficulty in raising further equity at good prices.
Taking on debt is among the simplest sources of finance. And it is also among the most common and popular sources of finance. A company can raise debt privately, i.e., from banks or any other financial institution. Or, it can raise debt from the public, i.e., by issuing corporate bonds or promissory notes. Additionally, a company can use debentures, leases, and mortgages to take on debt as well.
In case of a debt, companies or borrowers will have to pay regular interest payments and the principal amount at the maturity of the bonds/debentures. Regular payment of interest and payment of principal at Maturity is very, very crucial for the company as well as Investors/Lenders. The interest payments may hit cash flow sometimes adversely, and the company may feel a pinch in comfortable operations. Payment of principal amount at maturity requires a large amount of cash. And that may disrupt the ongoing operations substantially—any delay or non-payment of interest or principal dents the reputation and credibility of the company. Lenders and investors lose confidence in the company. And thus makes it more difficult for the company to raise further funds at a reasonable interest rate.
Therefore, requirements of cash flow irrespective of the business conditions for interest and principal payments remain a drawback of this source as well. If a company is unable to make timely payments, it may impact its reputation. And even force it to go for bankruptcy.
Talking of the pros, taking on debt is relatively easier than going for equity. Moreover, it could be less costly than other sources of finance. Also, interest payments on the debt help reduce the tax liability as they are tax-deductible. Thus, by a proper mix of debt and equity, the overall cost of capital can be optimized.
In this, investors get a tiny stake or ownership in the firm in return for their money. Basically, a company issues shares that investors can purchase. Once investors buy shares in a company, they become its shareholders, part-owners to the extent of their share value.
A company can raise equity capital both privately and publicly. If a company decides to raise money publicly, it needs to go for the IPO (initial public offering) and list its stock on a stock exchange. A company issues shares to a few selected investors in private equity financing. These investors could be individuals or institutions. Private equity and venture capital are an example of private equity financing.
In equity financing, there is no obligation on the company to pay back the money, like in the case of debt capital funding. Similarly, there is no obligation per se to pay dividends on regular basis to the shareholders. However, payment of regular dividends, rights, and bonus entitlements are the ways to remunerate the shareholders towards their investments and subscription. To keep a good image and enhance the stock value, a company not only needs to perform well but also needs to share part of the profits and growth with the shareholders on a regular basis.
Another drawback of equity financing is that it may dilute the company’s ownership control, making it a takeover target. It is also considered an expensive source of finance and does not offer any tax benefits as well.
Uses of Funds
Now that you know about the available sources of funds for the company let us take a few examples of how and for what purpose the companies may use their funds. Though these are common avenues, these are not sacrosanct, and the usage depends upon the requirements, the vision of the company, and the quantum of funds.
- A company can use the funds to develop a new product or service or make improvements to the existing products.
- Funding can help a business start its operation or convert its idea into reality.
- A company can use the funding to expand its operations by increasing its geographical reach in terms of increasing sales and servicing the area of operations. Or setting up installations/factories and offices in other parts of the country or in other countries.
- Another use of funds is to buy a new property, such as a new office space, a warehouse, or more. Similarly, a company can use the funds to buy new machinery and equipment.
- A company can also use the funds to complete any big order, which otherwise would have been impossible to complete.
- Innovation and ongoing feature updates are the key for sustaining and improving business operations. Therefore the company can use the available funds for research and development activities. Investing in R&D is one of the best tactics to beat the competition.
- Companies may also use the funds for their working capital requirements. Not being able to finance their working capital needs is the worst thing for a company and could result in bankruptcy. So, to keep the business running, a company may divert the funds towards the working capital.
- Using the funds for debt restructuring is also popular among companies. If the existing debt of a company is proving unmanageable, then the company can use new funds to restructure the debt. Generally, debt restructuring makes it relatively easier for the company to service and pay down its debt.
So, these are the sources and uses of funds. A point to note is that the above sources and uses of funds are not an exhaustive list, and there are more sources and uses of funds. But, the above-mentioned ones are the most popular and important sources and uses of funds. With the growth in the contour of business and new dynamics, several new instruments and routes of funding and usage are noticed nowadays.