8.1. Studying the Sources of Business Capital
Every business needs capital. Capital provides the money for the assets a business needs to carry on its operations. Common examples of assets are the working cash balance a business needs for day-to-day activities, products held in inventory for sale, and long-life operating assets (buildings, machines, computers, office equipment, and so on). One of the first questions that sources of business capital ask is: How is the business entity organized legally? In other words, which specific form or legal structure is being used by the business? The different types of business legal entities present different risks and offer different rewards to business capital sources.
Before examining the different types of business entities in detail, it's useful to look at the basic sources of business capital. In other words, where does a business get capital? Regardless of the particular legal structure a business uses, the answer comes down to two basic sources: debt and equity. Debt refers to the money borrowed by a business, and equity refers to money invested in the business by owners. Making profit also provides equity capital. No matter which type of business entity form that it uses, every business needs a foundation of ownership (equity) capital to persuade people to loan money to the business.
I might add that in starting a new business from scratch, its founders typically must invest a lot of sweat equity, which refers to the grueling effort and long hours to get the business off the ground and up and running. The founders don't get paid for their sweat equity, and it does not show up in the accounting records of the business. You don't find the personal investment of time and effort for sweat equity in a balance sheet.
8.1.1. Deciding on debt
Suppose a business has $10 million in total assets. (You find assets in the balance sheet of a business — see Chapter 5.) How much of the $10 million should be supplied by debt capital? As you probably know, there's no simple answer to such a question. Some businesses depend on debt capital for more than half of the money needed for their assets. In contrast, some businesses have virtually no debt at all. You find many examples of both public and private companies that have no borrowed money. But as a general rule, businesses carry some debt (and therefore have interest expense).
The debt decision is not really an accounting responsibility. Deciding on debt is the responsibility of the chief financial officer and chief executive of the business. In modest-sized and smaller businesses, the chief accounting officer (controller) may also serve as the chief financial officer. In larger-sized businesses, two different persons hold the top financial and accounting positions.
NOTE
Most businesses borrow money because their owners are not able or not willing to supply all the capital needed for its assets. As you know, banks are one major source of loans to businesses. Of course, banks charge interest on the loans; a business and its bank negotiate an interest rate acceptable to both. Many other terms and conditions are negotiated, including the term (time period) of the loan and whether collateral is required. The loan contract between a business and its lender may prohibit the business from distributing profit to owners during the period of the loan. Or, the loan agreement may require that the business maintain a minimum cash balance. Generally speaking, the higher the ratio of debt to equity, the more likely a lender will charge higher interest rates and will insist on tougher conditions, because the lender has higher risk that the business might default on the loan.
8.1.2. Tapping two sources of owners' equity
NOTE
The rights and risks of a business's owners are completely different than those of its debtholders. Whether you're a budding entrepreneur about to start up a new business venture or a seasoned business investor, you'd better understand the fundamental differences between the debtholders and shareowners of a business. Every business — regardless of how big it is and whether it's publicly or privately owned — has owners; no business can get all the capital it needs just by borrowing. Every business needs a continuing base of ownership (equity) capital.
Here's what business owners do:
Invest money in the business when it originally raises capital from individuals or institutions (for instance, when IBM issued shares of stock to persons who invested money in the company when it started up many years ago, or when three friends formed a partnership last year to start up Joe's Bar & Grill).
Expect the business to earn profit on their equity capital in the business and expect to share in that profit by receiving cash distributions from profit and by benefiting from increases in the value of their ownership shares — with no guarantee of either.
Directly participate in the management of the business or hire others to manage the business. In smaller businesses, an owner may be one of the managers and may sit on the board of directors, but in very large businesses you are just one of thousands of owners who elect a representative board of directors to oversee the managers of the business and to protect the interests of the owners.
Receive a proportionate share of the proceeds if the business is sold, or receive a proportionate share of ownership when another business buys or merges with the business, or end up with nothing in the event the business goes kaput and there's nothing left over after paying off the creditors of the business.
When owners invest money in a business, the accountant records the amount of money as an increase in the company's cash account. And, to keep things in balance, the amount invested in the business is also recorded as an increase in an owners' equity account. Owners' equity also increases when a business makes profit. (See Chapters 4 and 7 for more on this subject.) Because of the two different reasons for increases, and because of certain legal requirements regarding minimum owners' capital amounts that have to be maintained by a business for the protection of creditors, the owners' equity of a business is divided into two separate types of accounts:
Invested capital: This type of owners' equity account records the amounts of money that owners have invested in the business, which could have been many years ago. Owners may invest additional capital from time to time, but generally speaking they cannot be forced to put additional money in a business (unless the business issues assessable ownership shares, which is unusual). Note: A business may keep two or more accounts for invested capital from its owners.
Retained earnings: The profit earned by a business over the years that has been retained and not distributed to its owners is accumulated in this account. If all profit had been distributed every year, retained earnings would have a zero balance. (If a business has never made a profit, its accumulated loss would cause retained earnings to have a negative balance, which generally is called a deficit.) If none of the annual profits of a business had been distributed to its owners, the balance in retained earnings would be the cumulative profit earned by the business since it opened its doors (net of any losses along the way).
Whether to retain part or all of annual net income is one of the most important decisions that a business makes; distributions from profit have to be decided at the highest level of a business. A growing business needs additional capital for expanding its assets, and increasing the debt load of the business usually cannot supply all the additional capital. So, the business plows back some of its profit for the year rather than giving it out to the owners. In the long run this may be the best course of action because it provides additional capital for growth.