Capital is a necessary requirement to start up a business, operate and generate profits. Lack of capital may lead to business failure. A business can raise capital from the following main sources; debt, profits and sale of equity. The following are pros and cons of these sources of capital.
The main advantage of using equity as a source of capital for business is that it does not have fixed payment requirements or interest charges. Therefore it does not increase payment burden so the business can focus on growth.
A major disadvantage of equity financing is that when equity/shares are sold, the investor has ownership interest in the business and gets part of the profits. Therefore equity capital reduces the primary owner’s share of the profits and of the business as a whole.
Another disadvantage of equity capital is that equity investors demand a high rate of return on their investment. A business owner may end up giving up more stock for a lower price.
One advantage of using debt capital is that payments for debts are tax deductible. Therefore, using debts as a source of capital for a business is favourable because the tax deductibility of the debt payment will reduce taxes on some income.
In debt financing, the lender does not take up any part of your business; this is an advantage to the business owner as you get to keep full ownership of the business.
On the other hand, debt capital requires repayment of the borrowed principal and interest payments. This does not allow a business to keep its profits hence there is lack of flexibility and growth.
Another disadvantage of using debt financing is that it can cause cash flow difficulties. Lenders require the same amount of repayment every month regardless of whether the business is doing well or not. This can lead to defaults or late repayments.
3. Retained Profits
These are the part of profits that are not distributed to shareholders in the form of dividends but retained for financing growth of a business. This source of capital is only available for a business which has been trading for more than one year. Some of the advantages include;
The owner(s) of a business retain full ownership of the business because no part of the business is sold to a third party.
The other advantage is that retained profits are readily available and flexible to the business, therefore there is no need to ask for financing from elsewhere.
The main disadvantage of using retained profits is the high opportunity cost to the shareholders of the business. These profits could have been distributed to the shareholders as dividends but rather, they have been reinvested into the business.
There is no guarantee for the best method of raising capital. Financing methods will vary depending on different factors. The ability to raise capital for a business depends on good guidance, planning, and understanding which sources of capital are available for your business.