Welcome to the Engine Room: How Companies Get Their Cash!

Hello there! In this chapter, we are going to explore the various ways a company gets the money it needs to operate, grow, and take on new projects. Think of finance as the fuel for a business. Just like you might fund a car by using your savings, taking a loan, or asking a friend to chip in, companies have a variety of "taps" they can turn on to get capital.

By the end of these notes, you’ll understand the difference between Equity and Debt, the pros and cons of different funding sources, and how companies choose between them. Don’t worry if this seems tricky at first—we’ll break it down piece by piece!

1. Internal vs. External Sources of Finance

Before we dive into the specific methods, it is helpful to categorize where money comes from. There are two main buckets: Internal and External.

Internal Sources

This is money the company already has or generates itself. The most common example is Retained Earnings (or Retained Profits). This is the profit left over after the company has paid all its expenses and taxes, and hasn't yet given back to the owners as dividends.

Analogy: Imagine you want to buy a new laptop. Using your monthly savings is "Internal Finance." It’s "free" in the sense that you don’t owe anyone interest, but you are choosing not to spend that money on a holiday instead.

External Sources

This is money raised from outside the business. This includes asking the bank for a loan or inviting new investors to buy a piece of the company.

Quick Review: Internal finance is generally considered lower risk because there are no repayment obligations to outsiders, but there is a limit to how much profit a company can generate!

2. Equity Finance: Sharing the Ownership

Equity represents ownership. When a company issues shares, it is selling bits of itself to investors.

Ordinary Shares

These are the most common type of shares. Owners of ordinary shares are the ultimate risk-bearers of the company. If the company does well, they get dividends and the share price goes up. If it goes bust, they are last in line to get any money back.

  • Voting Rights: Usually, 1 share = 1 vote.
  • Dividends: Not guaranteed. They are only paid if the company makes a profit and the directors decide to pay them.

Preference Shares

Think of these as a hybrid between a loan and an ordinary share. They carry a fixed dividend (e.g., 5% of the face value). They are called "Preference" because these shareholders get their dividends before ordinary shareholders.

Did you know? Preference shareholders usually don't have voting rights. They trade away their "voice" in the company for the "security" of a more stable dividend.

Memory Aid: "Equity is Ownership"
If you are an Equity holder, you are a Part-Owner. You win when the business wins, but you lose first if it fails.

3. Debt Finance: Borrowing the Money

Debt is money borrowed from an outside source that must be repaid with interest. Unlike equity, lenders do not own the company; they are "creditors."

Key Characteristics of Debt:

  1. Interest: This is a legal obligation. Even if the company makes a loss, it must try to pay the interest.
  2. Priority: In a bankruptcy, debt holders are paid before shareholders.
  3. Tax Benefit: Interest payments are usually "tax-deductible," meaning they reduce the amount of profit the company is taxed on.

Common Types of Debt:

  • Debentures/Bonds: These are long-term loans traded on the stock market. The company issues a certificate (a bond) promising to pay back the loan at a certain date plus regular interest.
  • Bank Loans: Direct borrowing from a bank with a fixed or floating interest rate.
  • Mortgages: Loans secured against a specific asset, like a building.

Takeaway: Debt is "cheaper" for a company than equity because it is less risky for the investor and has tax benefits. However, too much debt (high gearing) can be dangerous if the company can't meet its interest payments!

4. Short-term vs. Long-term Financing

Companies need to match the "life" of the finance to the "life" of the asset they are buying. This is called the Matching Principle.

Short-term (Under 1 year)

  • Bank Overdraft: Very flexible but usually has high interest. Great for seasonal businesses.
  • Trade Credit: Buying goods now and paying the supplier in 30 or 60 days. It's essentially an interest-free loan!

Medium to Long-term (1 year+)

  • Leasing: Instead of buying a machine, the company "rents" it. This avoids a large upfront cost.
  • Hire Purchase: Like a car loan. You pay in installments and own the asset only after the final payment is made.

Common Mistake to Avoid: Don't use a long-term loan (like a 20-year mortgage) to pay for monthly electricity bills. Similarly, don't use a short-term overdraft to build a massive new factory. Match the duration!

5. Methods of Issuing New Shares

When a company needs a big injection of cash, it can issue new shares in several ways:

Rights Issue

The company offers existing shareholders the "right" to buy new shares, usually at a discount to the current market price. This is done in proportion to their current holding (e.g., a "1 for 5" issue means for every 5 shares you own, you can buy 1 new one).

The theoretical price after a rights issue is called the Theoretical Ex-Rights Price (TERP). It is calculated as:

\( TERP = \frac{(N \times P) + (S)}{\text{Total number of shares after issue}} \)

Where \( N \) is the number of old shares, \( P \) is the old price, and \( S \) is the subscription price of the new share.

Bonus Issue (Scrip Issue)

The company gives "free" shares to existing shareholders. No new money enters the company. It’s like cutting a pizza into 12 slices instead of 8—you have more pieces, but the same amount of pizza!

Why do a Bonus Issue? It makes the share price look "cheaper" and more accessible to small investors without actually costing the company any cash.

6. Specialized Sources: Venture Capital and Crowdfunding

Not every company can go to a big bank or the stock market. Younger or riskier companies use different methods:

  • Venture Capital: Professional investors who provide large sums of money to startups in exchange for a big chunk of equity. They also provide expertise and "mentoring."
  • Business Angels: Wealthy individuals who invest their own money in small businesses.
  • Crowdfunding: Raising small amounts of money from a large number of people, usually via the internet (e.g., Kickstarter).

Summary Checklist

Before you move on, make sure you can answer these:

  • What is the main difference between Equity and Debt? (Ownership vs. Borrowing)
  • Why is interest on debt "tax-efficient"? (It reduces taxable profit)
  • What is a Rights Issue? (Offering new shares to existing owners at a discount)
  • What is Retained Profit? (Internal money kept from previous years' earnings)

Don't worry if you need to read this a few times! The terminology can be heavy, but the logic is simple: a company always weighs up "How much will this cost me?" vs. "How much control am I giving away?"