External Funds
Every firm has the need to raise capital (funds) in order to finance the necessary purchase of assets (such as inventories and manufacturing plants) to run its business. While smaller amounts of financing are available from short-term sources for business operating needs (such as inventory or short-term working capital needs), larger amounts of capital are of a more permanent or long-term nature. The permanent/long-term sources of financing that a company uses are referred to collectively as the company’s capital structure.
The capital structure of a firm includes the long-term liabilities and equity sections of its balance sheet. Long-term liabilities and equity indicate how the company obtained the necessary money to buy the assets the company holds. In contrast to the working capital area, a firm’s capital structure relates to the firm’s permanent and long-term financing.
The sources of permanent and long-term financing may be broken down into external and internal sources.
External Funds
External funds may be raised through the issuance of debt securities, equity securities (common or preferred stock), long-term bank financing or other types of financing such as leasing.
Money raised from long-term debt financing may be in the form of a loan from a bank, or it may be raised from a debt issue, in which case it is a loan from the bondholders who buy the bonds. Money raised from equity financing is from a common stock or preferred stock offering, and it is an investment from the stockholders.
The company will need to pay for the use of the funds raised. The company’s payment may be in the form of interest for debt financing or dividends for equity financing.
A company’s long-term capital consists of both long-term debt (bank loans and debt issues) and equity (common and preferred stock).
A brief overview of the three main sources of long-term capital is below. Debt, common shares, and preferred shares:
Long-term debt
Most companies that borrow long-term will pay the interest as it is due and refinance (or “roll over”) the principal to pay off the existing debt when it matures. The refinancing of a bond issue is accomplished by selling more debt to pay off the maturing issue. Despite the fact that in reality long-term debt is not permanent (there is a maturity date), rolling over the debt makes it appear as though the debt is a permanent source of financing.
Borrowers are contractually liable to pay interest and principal when due and to adhere to any other requirements under the terms of the debt instrument. Failure to do so creates a default and the creditor can take actions that may put the company out of business, such as taking possession of any collateral security the debt or forcing the company into bankruptcy.
Preferred stock
Preferred stock is a type of equity security with characteristics of both bonds and common stock. Preferred stock is similar to bonds in that the dividends it pays are a percentage of the par value of each share, and it is like stock in that the principal does not have a maturity date and the dividend is not required to be paid every year. The dividend is a stated percentage of the stock’s par value, for example 6% per year. It may be paid quarterly, semi-annually, annually, or any other way the issuer determines. A preferred dividend is usually paid if it is at all possible to do so, but nonpayment of it does not cause a default and bankruptcy as does nonpayment of interest on debt.
Common stock
Common shares represent the voting ownership of the company. Common shareholders are able to vote on important issues for the company (for example, the appointment of the board of directors). Common shareholders are not guaranteed any payment from the company, but they may share in the distribution of profits in the form of dividends when the company distributes profits to the owners.
Dividends are paid from retained earnings. Issuers of common stock may or may not declare and pay quarterly dividends to the stockholders. Some companies do not pay dividends on their common stock but instead retain all their earnings in the company. Other companies pay dividends, and some have a policy of increasing the dividend periodically as long as they have earnings to support doing so. However, there is no requirement for a company to pay dividends on its common stock, and if a company’s board of directors does not declare a dividend, the company does not pay a dividend.