Different ways to obtain financing
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What are Sources of Funding?
Companies always seek sources of funding to grow their business. Funding, also called financing, represents an act of contributing resources to finance a program, project, or need. Funding can be initiated for either short-term or long-term purposes. The different sources of funding include:
- Retained earnings
- Debt capital
- Equity capital
Summary
- The main sources of funding are retained earnings, debt capital, and equity capital.
- Companies use retained earnings from business operations to expand or distribute dividends to their shareholders.
- Businesses raise funds by borrowing debt privately from a bank or by going public (issuing debt securities).
- Companies obtain equity funding by exchanging ownership rights for cash coming from equity investors.
Retained Earnings
Businesses aim to maximize profits by selling a product or rendering service for a price higher than what it costs them to produce the goods. It is the most primitive source of funding for any company.
After generating profits, a company decides what to do with the earned capital and how to allocate it efficiently. The retained earnings can be distributed to shareholders as dividends, or the company can reduce the number of shares outstanding by initiating a stock repurchase campaign.
Alternatively, the company can invest the money into a new project, say, building a new factory, or partnering with other companies to create a joint venture.
Debt Capital
Companies obtain debt financing privately through bank loans. They can also source new funds by issuing debt to the public.
In debt financing, the issuer (borrower) issues debt securities, such as corporate bonds or promissory notes. Debt issues also include debentures, leases, and mortgages.
Companies that initiate debt issues are borrowers because they exchange securities for cash needed to perform certain activities. The companies will be then repaying the debt (principal and interest) according to the specified debt repayment schedule and contracts underlying the issued debt securities.
The drawback of borrowing money through debt is that borrowers need to make interest payments, as well as principal repayments, on time. Failure to do so may lead the borrower to default or bankruptcy.
Equity Capital
Companies can raise funds from the public in exchange for a proportionate ownership stake in the company in the form of shares issued to investors who become shareholders after purchasing the shares.
Alternatively, private equity financing can be an option, provided there are entities or individuals in the company’s or directors’ network ready to invest in a project or wherever the money is needed for.
Compared to debt capital funding, equity funding does not require making interest payments to a borrower.
However, one disadvantage of equity capital funding is sharing profits among all shareholders in the long term. More importantly, shareholders dilute a company’s ownership control as long as it sells more shares.
Other Funding Sources
Funding sources also include private equity, venture capital, donations, grants, and subsidies that do not have a direct requirement for return on investment (ROI), except for private equity and venture capital. They are also called “crowdfunding” or “soft funding.”
Crowdfunding represents a process of raising funds to fulfill a certain project or undertake a venture by obtaining small amounts of money from a large number of individuals. The crowdfunding process usually takes place online.
Related Readings
Thank you for reading CFI’s guide to the Different Funding Sources. In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:
