You can tell a lot about a company from the way it strengthens a balance sheet.
In June this year, media reports suggested that after the mega success of a multibillion-dollar rights issue from Reliance Industries, many of India’s bigger companies had also begun thinking how they too could raise funds. These companies, the reports said, badly needed to reduce their debt burden and beef up their balance sheets – which had taken a severe beating because of the pandemic.
A few months later, the chief of the Reserve Bank of India (RBI), Shaktikanta Das, mentioned how his institution was ready to help “financial entities” raise funds, now that the Indian economy was at “the doorstep” of a revival.
These two developments underline the importance that businesses attach to capital – especially in the current situation, when companies across sectors and regions are reeling under the impact of the COVID-19 pandemic.
If you are new to investing in the stock markets, or are planning to, it is advisable to know how the company you are investing in (that is, buying shares of) is raising funds; it gives you an insight into its planning and its financial health.
When companies decide to spend money, it is usually in the hope that this would lead to profits in the future. They need funds to make expansions and grow the business, or maybe to start an R&D programme. This is called ‘funding’ – the act of contributing financial resources to execute a plan or project on hand. Such funding can be for either short-term or long-term purposes.
However, companies may not always have ready funds for this. In such cases, they have to seek new sources of capital. When companies choose sources of capital, they also choose how to pay for them, and the time period within which to do so.
Early stage businesses and start-ups usually raise funds from external sources such as private equity (PE) firms, venture capitalists, angel investors, etc. For a company that has been in business for a while, there are three other types of capital:
- Reinvesting of profits (this is called ‘retained earnings’)
- Borrowing through banks or bonds (this is called ‘debt capital’)
- Selling stock (this is called ‘equity capital’; Reliance Industries did this – ‘rights issues’ involve selling fresh equity shares to old shareholders)
Now let us look at each of these three sources of business finance to get a clearer picture.
1. Retained earnings
The primary aim of all businesses is to earn profits – that is, sell a product or provide a service at a price that is higher than what it cost them to produce those goods or provide that service.
Technically, these earnings and profits belong to the company’s shareholders, and if the promoters so wish, they are at liberty to distribute it among themselves. But this is akin to spending all of one’s salary without saving anything – and that does not make sense.
So what companies do with their profits is pay only a part as dividend to their shareholders, and use some of it to pay off debts, procure raw material, and maybe invest in R&D or expansion, and retain the rest. This retained amount is known as retained earnings. It is usually for carried over to the next accounting year; for instance, Shree Cements in its standalone cash flow statement , shows it as ‘Cash and Cash Equivalents as at the end of the Year’.
The cash flow shows details such as earnings from long-term and short-term borrowings, interest and financial charges paid, payments of liabilities, as well as dividend amount.
Essentially, retained earnings are that portion of a company’s net profit that is not paid out as dividend to its shareholders at the end of a financial year, but is retained for company use. These earnings are also part of shareholder equity – but more on that later.
This retained capital is what the company starts its operations with the following year, which makes it the most basic source of funds for a business: an internal source.
2. Debt capital
For a business to grow, companies would also need to look at external sources of funding. One way to do this is to borrow. This is called debt financing, and the money thus raised is called debt capital.
Debt financing can be done in two ways: privately through bank loans, or publicly by issuing debt securities such as corporate bonds, promissory notes, debentures etc. It encompasses both secured and unsecured loans, and carries a predetermined maturity date, by when the principal needs to be repaid. Failure to clear payments on time can lead to foreclosing of the loan or even bankruptcy. In the case of secured loans, the collateral can be used to meet the liability.
Debt capital also involves borrowing at fixed interest rates, which is basically the cost of debt. Though interest payouts are tax deductible, bondholders need to be paid interest on time, and this can cause pressure on cash flow.
It is easier to attract financing through the debt route if the promoters have invested heavily in the business and have a high proportion of equity to debt.
Debt financing has its pros and cons. On the plus side, it allows a company to raise funds without having to issue new shares and thereby diluting the equity holdings of existing shareholders, who can oppose such a move. On the flip side, debt finance brings repayment pressure on cash flow, as defaults can lead to loan foreclosure or bankruptcy of the company.
That apart, the loan agreement may have restrictive clauses preventing the borrowing company from undertaking certain activities during the repayment period. Moreover, a loan can also reduce the company’s net worth, causing its share value to drop.
Related: A beginner’s guide to capital markets
3. Equity capital
The third type of funds that companies raise is called equity capital – the money that retail (individual) and institutional investors pay for the company’s stock or equity shares.
These investors become the company shareholders, with the equity capital constituting their stake in the company, which is identified on the company's balance sheet. Technically, the company’s earnings belong to the shareholders, which is why retained earnings are part of shareholder equity.
Also called equity financing or share capital, shareholder equity represents the total money that would be have to be returned to the shareholders if the company in question is liquidated, all its assets sold off, and its debts squared off.
Equity capital can also be in the form of private equity, which is not publicly traded, and provided mostly by venture capitalists (VCs), usually for an early minority stake. In fact, VCs sometimes sit on the company board and take an active role in its management.
Equity capital also has its share of advantages and disadvantages. First, on the plus side, it does not require making interest payments to the investors. Second, the company has no obligation to redeem the shares, or pay dividends in case of losses, without being legally penalised for that. What’s more, raising equity capital makes a company answerable to shareholders, which ups its creditworthiness.
This brings us to the flip side – from the management’s point of view. Shareholders dilute a company’s ownership control. And if it sells more shares later, the ownership gets diluted further.
Related: What you need to know about equity funds?
All companies, at some time or the other, feel the need to raise capital from external sources: sometimes it is through IPOs, and at other times by means of rights issues, private placements, or even straightforward borrowing. They need the capital to grow their businesses, break into new markets, invest in R&D, or (as is the case now with many) strengthen their balance sheets in the current situation and tap any opportunities that may emerge from it.
Whatever the reason to raise business capital, studying the major sources of funding of a company can help you – as a shareholder or investor – to assess a business. For instance, if you see a company with excessive debt, you can expect it to run into problems. Conversely, if a company gives external capital a deliberately wide berth, perhaps it is in danger of missing a few growth prospects.
Either way, as an investor, you can take a call. Know more about investing in money markets vs capital markets.