Raising financing

When a company needs additional funds, it can use either internal or external sources, or both, depending on whether it seeks large amounts of funding for long-term growth, such as an expansion, or smaller amounts for short-term expenses, such as to cover operating costs. In addition, the number of external sources available depends on whether the business is well established or whether it is relatively new and without much of a track record.

Sources of financing and capital

When considering the prospect of raising financing, the financial directors will first evaluate the financial health of the company. They will then decide what proportion of the company will be funded by equity (the company’s own reserves of cash and money raised from issuing shares) and what proportion will be funded by borrowing money from an outside source, such as a bank, so that the company takes on debt.

EVALUATING CAPITAL STRUCTURE

When investors consider buying shares in a company, they look at its capital structure to assess the future prospects of the business. The capital structure refers to the percentage of a company’s finances made up of funds from shares and earnings, called equity, and the percentage made up from borrowed funds, or debt. When evaluating capital structure, investors consider the following:

❯ As a general rule, companies with more equity than debt are considered less risky to invest in because their assets outweigh their liabilities. So a company with significantly more equity than debt has a low debt-to-equity ratio and is generally seen to be a low-risk investment.

❯ A company with significantly more debt than equity has a high debt-to-equity ratio and is more risky as an investment.

❯ Debt is not always bad. If interest rates are low a company could take on more debt to fund expansion, as long as the revenue it makes from the borrowed funds is
greater than the interest payable. So although this company may be more risky, it may also have greater potential for growth—this is known as “gearing.”

Debt and loans

Institutional lenders
Money loaned by large financial bodies, such as banks.

FUNDS IN THE FORM OF A LOAN FROM AN OUTSIDE SOURCE

Equity

Profit from business activities Proceeds of the core business.

Shareholders’ stake in company
Payment received for shares in the company.

DIVIDENDS—PAID ONLY WHEN A COMPANY MAKES ENOUGH PROFIT

Bonds

Investor lenders Payments made by bondholders.

59%
of US financial managers say financial flexibility is the most important factor in deciding how much debt the company takes on