Money makes not just the world, but businesses to go round, too. Be it to sustain day-to-day expenses or to expand business in order to earn more, money is a requisite to putting any business plans in action. This article explores the usage of retained earnings and debt capital as sources of funds available to an incorporated entity.
1. Retained earnings
Businesses earn profits by selling products or services at prices higher than the costs to produce the same. The revenue brought in, after deducting all expenses and costs are retained earnings. Retained earnings are arguably the easiest, most accessible source of fund to a company to sustain business and potentially expand.
Reinvesting retained earnings is cost-effective. It is much less expensive compared to raising money externally. Allocation and management of retained earnings can be dealt with internally, often by the corporate finance team or otherwise. Such extra earnings are generally free to be used as the company wishes, typically through the passing of board resolutions in accordance with the company’s constitution in order to make such decisions.
However, retained earnings may be limited. While it may be sufficient to cover day-to-day costs of operation, it would likely not be enough if the company is seeking to plough in new projects requiring substantial initial capital. At this juncture, the company may consider raising finance externally, and if so, the company would have to decide whether to raise equity capital or debt capital.
2. Debt capital
As the name suggests, debt capital involves different forms of borrowing. Be it through a bank loan or done publicly through debt issues.
2.1 Bank loans
Depending on the amount of capital required, bank loans may range from relatively simple bilateral loans (that is, only one lender to one corporate borrower) to sophisticated syndicated financing. The latter involves the pooling of funds from a group of banks to (usually) one corporate borrower on records, but with its affiliated companies involved in providing some form of security or guarantee in favour of the banks.
Such bank loans are private matters. Save for certain overarching regulations under, say, the provisions of the Financial Services Act 2013 (or its Islamic counterpart, the Islamic Financial Services Act 2013) and the Moneylenders Act 1951, the commercial terms between parties (such as amount of interest to be paid, repayment period and covenants to be complied with) are to be negotiated by the parties themselves, typically influenced by the market.
From the banks’ perspective, they are essentially investing in the company. Banks would have the advantage to conduct market and credit research and to hire external professionals such as lawyers and valuers to assist in making an informed investment decision and to impose certain conditions to safeguard the bank’s interest. While all lending activities and investment decisions would inherently carry some form of risk of the company going bust and defaulting due to unprecedented circumstances (the COVID-19 pandemic being an obvious example), such risks can be reduced through in depth know-your-customer checks, sophisticated financing structuring (one that involves granting the bank a lot of security) and professional market research.
2.2 Debt issue
Alternatively, the company may choose to issue debt capital. This is usually in the form of a bond, which is really, crudely, just a contract that recognises the debt owed by the company to the investor / bondholder and the payment obligations involved. If the issuance bond is compliant with Shariah principles (for instance, where the usage of the proceeds are Shariah-compliant), the bond is known as a Sukuk.
This is a form of debt capital because it is essentially a form of lending of a principal sum to the borrower company for a fixed period of time, on the condition that the company pays a fixed return in the form of interest to the bondholder at stipulated intervals and ultimately returning the entire principal sum when the bond expires.
From the investor’s perspective, the investor would only invest and buy such bonds or Sukuk if the investor has confidence that the borrower company is able to pay the interests promised under the terms of the bond or Sukuk purchased. Otherwise, the investor bears the risk of the company going bust or failing the project to which the proceeds of the bond or Sukuk was meant for and ultimately not being able to repay the promised returns and principal amount.
Conclusion
In conclusion, the company would choose funding method best suited to its needs which may be affected by, among others, market factors, costs of lending, its own ability to repay and the readiness of the industry.
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