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Business Capital
Sources



T
This chapter explores the two basic sources of business capi-
tal: debt and owners™ equity. Every business must make a fun-
damental decision regarding how to finance the business,
which refers to the mix or relative proportions of debt and
equity. By borrowing money, a business enlarges its equity
capital, so the business has a bigger base of capital to carry
on its profit-making activities. More capital generally means a
business can make more sales, and more sales generally
mean more profit.


Using debt in addition to equity capital is referred to
as financial leverage. If you visualize equity capital
as the fulcrum, then debt may be seen as the lever that serves
to expand the total capital of a business. The chapter explains
the gain or loss resulting from financial leverage, which often
is a major factor in bottom-line profit.

It™s possible, I suppose, to find a business that is so antidebt
that the only liabilities it has are normal operating liabilities
(i.e., accounts payable and accrued expenses payable).
These short-term liabilities arise spontaneously in making
purchases on credit and from delaying the payment of certain
expenses until sometime after the expenses have been

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recorded. A business can hardly avoid operating liabilities.
But a business doesn™t have to borrow money. A business
could possibly raise all the capital it needs from shareowners
and from retaining all or a good part of its annual earnings in
the business. In short, a business theoretically could rely
entirely on equity capital and have no debt at all”but this
way of financing a business is very rare indeed.


BUSINESS EXAMPLE FOR THIS CHAPTER
Figure 6.1 presents a very condensed balance sheet and an
abbreviated income statement for a new business example.
The income statement is truncated at earnings before interest
and income tax (EBIT). The two financial statements in Figure
6.1 are telescoped into a few lines. In this chapter we don™t
need all the details that are actually reported in these two
financial statements. (See Figure 4.2 for the full format of a
balance sheet and Figure 4.1 for a typical format of an exter-
nal income statement.)
To support its $18.5 million annual sales, the business used
$11.5 million total assets. Operating liabilities provided $1.5
million of its assets. In Figure 6.1 the company™s operating lia-
bilities are deducted from its total assets to get a very impor-
tant figure”capital invested in assets. The business had to
raise $10 million in capital from debt and owners™ equity. The
business borrows money on the basis of short-term and long-
term notes payable. The business built up its owners™ equity




Balance Sheet Income Statement

Assets used in making profit $11,500,000 Sales revenue $18,500,000
Operating liabilities All operating
(accounts payable and expenses ($16,700,000)
accrued expenses payable) ($ 1,500,000) Earnings before
Capital invested in assets $10,000,000 interest and income
Debt and equity sources of tax expenses (EBIT) $ 1,800,000
capital $10,000,000

FIGURE 6.1 Condensed financial statements.



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B U S I N E S S C A P I TA L S O U R C E S


from money invested by shareowners plus the cumulative
amount of retained earnings over the years (undistributed net
income year after year).


Once Again Quickly: Assets
and Operating Liabilities
Chapter 5 explains that a business that sells products
on credit needs four main assets in making profit:
cash, accounts receivable, inventories, and long-lived
resources such as land, buildings, machinery, and equipment
that are referred to as fixed assets (or, more formally, as prop-
erty, plant, and equipment). The chapter goes into the charac-
teristics of each asset, explaining how sales revenue and
expenses are connected with these assets. Chapter 5 also
explains how expenses drive the operating liabilities of a busi-
ness. In the process of making profit a business generates cer-
tain short-term, non-interest-bearing operating liabilities that
are inseparable from its profit-making transactions. These
payables of a business are called spontaneous liabilities because
operating activities, not borrowing money, causes them. Oper-
ating liabilities are deducted from total assets to determine the
amount of capital that has been raised by a business.


CAPITAL STRUCTURE OF BUSINESS
The capital a business needs for investing in its assets comes
from two basic sources: debt and equity. Managers must con-
vince lenders to loan money to the company and convince
sources of equity capital to invest their money in the company.
Both debt and equity sources demand to be compensated for
the use of their capital. Interest is paid on debt and reported
in the income statement as an expense, which like all expenses
is deducted from sales revenue to determine bottom-line net
income. In contrast, no charge or deduction for using equity
capital is reported in the income statement.

Rather, net income is reported as the reward or payoff on
equity capital. In other words, profit is defined from the
shareowners point of view, not from the total capital point of
view. Interest is treated not as a division of profit to one of the
two sources of capital of the business but as an expense, and

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profit is defined to be the residual amount after deducting
interest.
Sometimes the owners™ equity of a business is referred to
as its net worth. The fundamental idea of net worth is this:
Net worth = assets ’ operating liabilities ’ debt
Net income increases the net worth of a business. The busi-
ness is better off earning net income, because its net worth
increases by the net income amount. Suppose another group
of investors stands ready to buy the business for a total price
equal to its net worth. This offering price, or market value, of
the business increases by the amount of net income. Cash dis-
tributions of net income to shareowners decrease the net
worth of a business, because cash decreases with no corre-
sponding decrease in the operating liabilities or debt of the
business.
The amounts of cash distributions from net income are
reported in the statement of cash flows, which is explained in
Chapter 2. Dividends are also reported in a separate state-
ment of changes in owners™ equity accounts if this particular
schedule is included in a financial report (see Figure 4.4 for
an example).
The valuation of a business is not so simple as someone
buying the business for an amount equal to its net worth.
Business valuation usually takes into account the net worth
reported in its balance sheet, but many other factors play a
role in putting a value on a business. The amount a buyer is
willing to offer for a business can be considerably higher than
the company™s net worth based on the figures reported in the
company™s most recent balance sheet. The valuation of a pri-
vately owned business is quite a broad topic, which is beyond
the scope of this book. Likewise, the valuation of stock shares
of publicly owned business corporations is a far-reaching
topic beyond the confines of this book.

At its most recent year-end, the business had $10 million
invested in assets to carry on its profit-making operations
(total assets less its operating liabilities). Suppose that debt
has provided $4 million of the total capital invested in assets
and owners™ equity has supplied the other $6 million. Collec-
tively, the mix of these two capital sources are referred to as
the capitalization or the capital structure of the business. Be

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careful about the term capitalization: Similar terms mean
something different. The terms market capitalization, market
cap, or cap refer to the total market value of a publicly traded
corporation, which is equal to the current market price per
share of stock times the total number of stock shares out-
standing (in the hands of stockholders).
A perpetual question that™s not easy to answer concerns
whether a business is using the optimal or best capital struc-
ture. Perhaps the business in the example should have carried
more debt. Maybe the company could have gotten by on a
smaller cash balance, say $500,000 less”which means that
$500,000 less capital would have been needed. Perhaps the
business should have kept its accounts receivable and inven-
tory balances lower, which would have reduced the need for
capital. Every business has to make tough choices regarding
debt versus equity, asking shareowners for more money ver-
sus retaining earnings, and working with a lean working cash
balance versus a larger and more comfortable cash balance.
The answers to these questions are seldom easy and clear cut.


Basic Characteristics of Debt
Debt may be very short term, which generally means six
months or less, or it may be long term, which generally means
10 years or longer”or for any period mutually agreed on
between the business and its lender. The term debt means
interest-bearing in all cases. Interest rates can be fixed over
the life of the debt contract or subject to change, usually at the
lender™s option. On short-term debt, interest usually is paid at
the end of the loan period. On long-term debt, interest usually
is paid monthly or quarterly (sometimes semiannually).


A key feature of debt is whether the principal of the
loan (the amount borrowed) is amortized over the
life of the loan instead of being paid at the end of the loan
period. In addition to paying interest, the business (who is the
borrower, or debtor) may be required to make payments peri-
odically that reduce the principal balance of the debt instead
of waiting until the final maturity date to pay off the entire
principal amount at one time. For example, a loan may call
for equal quarterly amounts over five years. Each quarterly

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payment is calculated to pay interest and to reduce a part of
the principal balance so that at the end of the five years the
loan principal will be paid off. Alternatively, the business may
negotiate a term loan. Nothing is paid to reduce the principal
balance during the life of a term loan; the entire amount bor-
rowed (the principal) is paid at the maturity date of the loan.
The lender may demand that certain assets of the business
be pledged as collateral. The lender would be granted the
right to take control of the property in the event the business
defaults on the loan. Real estate (land and buildings) is the
most common type of collateral, and these types of loans are
called mortgages. Inventory and other assets also serve as col-
lateral on some business loans. Debt instruments such as
bonds may have very restrictive covenants (conditions) or,
conversely, may be quite liberal and nonbinding on the busi-
ness. Some debt is convertible into equity stock shares,
though generally this feature is limited to publicly held corpo-
Y
rations whose stock shares are actively traded. The debt of a
FL
business may be a private loan, or debt securities may be
issued to the public at large and be actively traded on a bond
market.
AM


Lenders look over the shoulders of the managers of the
business. Lenders do not simply say, “Here™s the money and
call us if you need more.” A business does not exactly have to
TE




bare its soul when applying for a loan, but the lender usually
demands a lot of information from the business. If a business
defaults on a loan (not making an interest payment on time or
not being able to pay off the loan at maturity), the terms of the
loan give the lender legally enforceable options that in the
extreme could force the business into bankruptcy. If a busi-
ness does not comply fully with the terms and provisions of its
loans, it is more or less at the mercy of its lenders, which
could cause serious disruptions or even force the business to
terminate its operations.

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