Capital Sources: Internal, Trade, Debt and Equity

You need money to advertise, market, sell, stock inventory, pay employees, extend trade credit, rent a facility, purchase equipment, pay taxes, etc., etc. And nothing soaks up cash like success (i.e. sales growth). So, you search for money. Take caution, however. All money is not the same. Fail to appropriately match financing need with type and you’ll risk losing profit, time, credibility, or worse.

This article explains the various types of capital and the appropriate uses of each. Enhance your understanding of types and uses and you will be a better manager and business owner. It will certainly save you time and money. It could even save your business.

Money or Capital?

For some reason, many business people don’t like to use the word “money.” It’s gauche, so the word “capital” is often used instead. From a textbook perspective, “capital” refers to money, labor, raw materials and other “factors of production.” Regardless, when people use the word “capital” today they typically mean “money.” In this article we will use the terms money, cash and capital synonymously.

Short-Term and Long-Term

Capital can be classified as either short-term or long-term. Short-term is less than one year. A common short-term need is seasonal increases in “working capital”- the money tied up in the balance between the working accounts (receivables, inventory and accounts payable). Working accounts turn over quickly. Take for example, a seasonal business that needs money to buy and build inventory in anticipation of the busy season. The loan is short term and should be paid off when sales are turned into cash. Another example is the contractor that needs money to fund work-in-process until projects can be completed, billed and collected.

Long-term is more than a year. Long-term financing is used to fund the purchase of assets that generate value for more than a year, such as property and equipment. Long-term financing can be debt or equity, and may be appropriate to fund permanent (non-seasonal) increases in working capital.

There are four primary sources of money: internal, trade, debt and equity.

Internally Generated Funds

Internal funds are those generated from or within the business itself. The most important internal source is profit, or more accurately, cash flow. The amount available, of course, is a function of how much is generated and retained in the business.

A non-recurring source of internally generated capital may be found by wringing out cash tied up in the balance sheet. This might include selling some machinery or equipment that is not necessary or is too expensive, or the unlocking of cash tied up in working capital. Here is Savvy Company’s working capital:

As can be seen, Savvy has $500,000 tied up in working capital (current assets minus current liabilities). However, if the business institutes practices that allow it to maintain less inventory and collect more rapidly on receivables, for example, cash can be generated (tax free).

For example, let’s say that by devising and instituting some new policies, Savvy is able to support the current level of annual revenue with just $450,000 in receivables (because they collect more quickly) and $200,000 in inventory (because they become able to turn inventory more quickly), working capital can be reduced to $350,000 … $150,000 in cash is generated.

Obviously, business managers should consider internal sources of cash, regardless of whether the cash is needed to fund business activities or could be distributed to the equity holders. Internal sources of capital are most desirable, reliable and lowest cost.

Note: Internally generated cash actually becomes equity once it flows into the business, so be sure to read the equity section below.

Trade Credit

Trade credit is what we call “terms” extended by suppliers. They send you goods but don’t require you to pay for, say, 30 days. Trade credit is an absolutely essential and life-giving source of capital for most businesses.  It is a substantial portion of the capital structure of most businesses and, best of all, is interest free.

Because of the low cost, most businesses attempt to maximize the trade credit they can obtain. Seasoned business owners preach caution in stretching trade credit balances, as trade credit may be most valuable during times of trouble. If your trade creditors are pushed to the limit all the time, there will be no room for more when the inevitable “pinch” hits.

Trade credit is unsecured debt, meaning the suppliers don’t require you to pledge any assets against the “loan.” This means that if the business fails and there is no money left over after the secured creditors are paid, the trade creditors will go unpaid. So, when you hear someone say “suppliers cut them off” or “put them on COD,” it’s because trade creditors need to be cautious.

Debt Capital

Debt is simply the borrowing of money with a promise to repay … with interest. Banks are the primary debt lenders in our society, but credit unions, investment banks and insurance companies also lend money. The amount borrowed and terms of repayment are usually documented in writing via a promissory note or “note,” signed by both lender and borrower.

The term may be for days or years, and it is imperative that the term and terms match the use. For a short-term need, such as the financing of a large receivable that should be collected soon, the note term should match. For assets with a long productive life such as real estate, long-term loans are appropriate.

Some notes call for regular payments of principal and interest, such as a loan to buy equipment. Others are interest only. It is not chance that dictates whether principal is due in installments or all at once at maturity. Regular principal payments are appropriate when the borrowing is for an asset that has a steady productive life and should regularly generate profits (or contributing to such). If the purpose is seasonable working capital, it makes sense to repay principal in full at the end of the season, for example.

Interest-bearing debt financing is sought when trade debt sources are extinguished.  Interest-bearing debt is more expensive than trade debt but it’s cheaper than equity. It is also generally considered more risky than equity for two reasons:

a. Debt capital requires repayment according to specific terms. The expense and repayment both consume cash on an ongoing business. And, if you fail to meet the terms, you could be sued or assets could be seized for repayment.

b. Lenders (those that provide interest-bearing debt capital) enjoy a priority claim on the assets of the business. That means that if the business becomes unable to pay its bills, the assets of the business will first go to repay the debt lenders. More particularly, the secured creditors (lenders of debt) are paid first, then the unsecured creditors such as trade creditors. Then, if there is money left over, it will go to the owners (equity holders).

In a secured loan, the borrower pledges certain assets as collateral (security) to protect the lender in case of default on the loan. If the business defaults on the loan, the note holder (lender) assumes ownership of the collateral. In long-term borrowing, fixed assets such as real estate or equipment are usually pledged as collateral. For short-term borrowing, inventories or accounts receivable are the norm. Credit cards are a form of unsecured debt capital.

Equity Capital

Equity capital is the longest term financing available to a business. In fact, it’s considered permanent (no repayment term). Yes, equity capital comes with no payment obligation and monies only flow to the equity holders when all other obligations have been met. This means that equity capital is the most risky. If the business does not succeed and must be liquidated, the equity holders only get what is left over (if any).

Equity capital is the most expensive form of capital. This makes sense when you consider the risk. For example, a loan (debt financing) today might charge an annual rate of seven or eight percent. Try to sell an equity stake in your business and investors might demand well north of 30%. Now, if the terms of the equity sale require a return, it’s not really a pure equity position. When we say, “demand well north of 30%,” we mean the investor must believe he will earn it (their “hurdle rate”) … or he won’t invest.

Equity capital is illiquid (hard to sell). Unlike trade credit or a bank loan, which can be replaced easily with another supplier or lender, equity is not easy to sell or exchange. This is another reason for the higher rate of return – compensation for the risk inherent in the illiquidity.

Many businesses don’t earn a return for their investor(s). This is common in small businesses where the equity holder (owner) is also the full time manager. The owner will pay himself or herself a salary (wage for his or her contribution of time and talent) and there will be little or no profit left over. If equity distributions are made, it’s allocated on a pro-rata basis (i.e. according to ownership percent), unless there is more than one class of stock (rare in a small business).

Equity is the foundation of a business’ capital structure. The way a business is financed is referred to as its capital structure. Another way to understand “capital structure” is to identify the source of the money. The most important piece is the equity. If the equity contribution is sufficient, other types of capital providers might be willing to contribute capital (money) to your business. For example, if you need $500,000 in equipment, a lender will typically not lend you $500,000. After all, tangible assets decline in value over time and, given that lenders charge fairly low rates of interest, they can’t afford a lot of risk (lost principle). Lenders need a cushion. They want you to contribute, say, 20 percent of the purchase price with equity. Then they will lend the other 80 percent. If you default on the loan, they will get the entire piece of equipment and your equity will be lost. Just as the equity serves as a cushion for the lender on the equipment loan, the overall level of equity in the business serves as a cushion for all non-equity contributors of capital.

Does all this sound unfair? Before you, the equity holder, get too uncomfortable, consider that the trade creditor earns no interest. The debt capital provider just gets a few percentage points in interest and some fees. You, the equity holder, can earn as high a return as you are able to muster. There is no limit to your upside.

Equity is also unique in that the holders of equity dictate how the business is managed. They, in effect, are the people who determine the other capital sources. Therefore, equity is the most risky capital, but the holders of it have the most influence in how the business is managed.

Finally, growing companies consume cash. It’s just the way it works. Sales and profit growth follow expenditures such as:  the hiring of additional employees; the purchase of more inventory, materials and equipment; the leasing of a larger facility, etc. And, as we discussed above, creditors (debt and trade credit) don’t want to finance 100 percent. So, growing businesses need a continuous supply of equity capital – internal generated cash or equity obtained from investors.

Summary

Money is the lifeblood of a business. Business owners must understand sources and uses of money (capital) to be effective. By effective, we mean appropriately match the need with the type so that the business remains well capitalized (has enough money), does not run into financial crisis (liquidity crunches that inordinately distract management, damage credibility and increase risk), and minimize cost of capital and therefore maximize the return to the equity holders.

This article was written by the experts at The Business Owner. If you are the owner of a private business, go to www.TheBusinessOwner.com or call us at (800) 634-0605 for more no-nonsense how-to information.