This article contains general information and is not intended to provide information that is specific to American Express, or its products and services. Similar products and services offered by different companies will have different features and you should always read about product details before acquiring any financial product.
Capital is the fuel that drives a business forward. It provides the financial resources necessary for both day-to-day operations and growth. There are three primary sources of capital in business: retained earnings, debt capital, and equity capital.
Before committing to a source – or multiple sources – of capital, here are steps you may consider. First, determine your specific financial needs and goals. Next, assess available financing options to understand the requirements, potential benefits, and risks of each choice. Then, through strategic planning, you may be ready to select the most appropriate sources of capital to build both short-term and long-term financial strength.
What Is the Definition of Capital in Business?
Capital includes all the financial resources a business uses to grow, generate profits, and cover operating expenses like rent, material costs, and salaries. Businesses might generate capital from internal sources, such as through the sales of goods and assets, or receive it from external sources, such as lenders and investors.
To help maintain positive cash flow and remain competitive, businesses might use budgeting, financial planning, and cost controls to help manage their capital. With sufficient capital, businesses could purchase assets, pay down debts, hire employees, and expand into new markets.
Types of Funding for Businesses
Three primary sources of business capital are:
Retained earnings (reinvested profit)
Debt capital (borrowed funds)
Equity capital (funds exchanged for partial ownership)
Businesses may rely on more than one of these funding sources to obtain capital, and the appropriate choices vary with the business’s type and industry. Finding the right capital funding might prove crucial, as each option has its own requirements, advantages, disadvantages, and long-term financial implications.
Retained Earnings
Retained earnings refer to the net income reinvested into the business, rather than being distributed to shareholders. As a cost-effective internal business capital source, retained earnings may allow companies to finance operations and growth without debt or ownership dilution. This means owners retain control, stability, and flexibility as the business grows. However, overreliance on retained earnings may lead to missed opportunities, especially if cash is generated too slowly to fund potential growth opportunities or explore alternative growth strategies.
Finding the right capital funding may be important, as each option has its own requirements, advantages, disadvantages, and long-term financial implications.
Retained earnings may be generated from various sources, including:
Operating profits: Retained earnings primarily come from a company’s operating profits. These profits are calculated by subtracting operating expenses (including cost of goods sold and administrative costs) from the revenues generated from core business activities, such as selling goods or services. The portion of these profits not distributed to shareholders becomes retained earnings.
Asset sales: When a company earns income from asset sales, such as property or equipment, gains may be reinvested as retained earnings.
Investment income: If a company has investments in other businesses, such as bonds or property, the income generated from these investments may contribute to retained earnings.
Debt Capital
Debt capital may refer to funds acquired from lenders, with the obligation to repay the principal amount over a set period, with interest. Capital from debt could give businesses a cash infusion, but decision makers might want to carefully analyze the terms and long-term financial implications of debt payment obligations before borrowing. Factors to consider before borrowing may include: the size and frequency of payments, potential ROI when using the funds, ability to meet repayment obligations, and strain on future cash flow.
Debt capital may come from diverse sources, including:
Commercial banks: These financial institutions offer loans to businesses with established credit and a detailed plan for fund utilization. Before approval, potential borrowers may have to demonstrate their ability to repay the debt or offer collateral. Businesses might consider prioritizing exploring existing banking relationships when seeking loans, as established trust and a proven track record could demonstrate creditworthiness when discussing loan terms.
Alternative lending sources: Businesses that may not qualify for traditional bank loans could turn to other borrowing options, such as specialized lenders, business lines of credit (like the American Express® Business Line of Credit1), or peer-to-peer (P2P) lending platforms. For example, a manufacturing company without a long credit history may go to a specialized asset-based lender to obtain enough capital to help purchase new equipment. Terms, rates, fees, collateral requirements, and other lending criteria may vary by lender, so businesses should carefully consider the long-term financial implications before borrowing.
Leasing companies: Leasing allows businesses to rent assets, such as equipment or vehicles, rather than purchasing them outright. This may be a cost-effective alternative to traditional debt financing, as it may offer lower monthly payments and greater flexibility for expensive equipment, especially for businesses with changing or temporary equipment needs. Businesses with long-term equipment needs, however, may end up spending more on monthly lease payments than they would have if they bought the equipment outright. Cost-benefit analyses, factoring in the resale value of owned equipment, may help determine the best option when acquiring assets.
Bonds: Companies may also raise debt capital by issuing corporate bonds. Bonds are debt securities that allow investors to lend money to the company in exchange for regular interest payments and the return of the principal amount at a predetermined time, known as the maturity date. Issuing bonds could provide businesses with an injection of cash, but the process may be more complex than traditional loans.
Trade credit: By balancing credit terms – both from suppliers and offered to customers – businesses may be able to obtain direct financing to support their growth. For example, a business can buy supplies on credit and invest those procurement funds into growth before the bill comes due.
Equity Capital
When investors exchange funds for an ownership stake or a percentage of shares in the business, it’s referred to as equity capital. This is a common way to raise funds for businesses that have high growth potential but neither the cash flow nor collateral needed to secure traditional debt financing. Equity capital allows businesses to raise funds without taking on debt, but it also means that the company’s owners may have to share their profits and decision-making power with the new investors. This may dilute ownership, potentially reducing control over the company and the amount of profits that could be reinvested as retained earnings.
Some common sources of equity capital are:
- Private investors: Startups may seek initial equity capital from individual or small groups of private investors, also known as angel investors – individuals who are willing to take risks on early-stage companies to seek potential returns. Businesses seeking angel investors might want to pitch their business’s potential and future growth plans.
- Institutional venture capital firms: Venture capital firms use professionally managed funds to invest in high-growth potential companies and earn high returns for their investors. These firms may focus on specific stages of company development or industries, such as tech, and tend to provide valuable guidance and resources to businesses in addition to capital. Like with angel investors, businesses seeking venture capital may have to compete with other potential candidates to earn these investments.
- Strategic investors and corporate venture capitalists: Some large corporations have their own venture capital arms that invest in companies that align with their strategic objectives. These investments may provide capital alongside the corporation’s resources, expertise, and networks, often in exchange for specific benefits, such as access to technology, information, or research.
- Private equity firms: Private equity firms may opt to invest in established companies with strong cash flows and assets. These firms could acquire a large stake in a company and then work with management to pursue growth initiatives before selling their stake for a profit. Private equity investments may provide significant capital for expansion or restructuring but may require owners to give up some control.
- Crowdfunding: Crowdfunding platforms allow businesses to raise small amounts of money from a large number of individuals. This may be an effective way to raise capital without giving up significant equity or control, especially for startups and small businesses. However, crowdfunding campaigns may be time-consuming and unreliable; they may require extensive marketing and results can be difficult to predict.
- Overseas investors: Foreign investors, including banks, leasing companies, and stock exchanges, may be interested in financing U.S.-based companies. However, businesses should carefully consider differences in management styles and language barriers, as well as any other implications, before engaging in international financial transactions.
- Intermediaries: Earning equity capital could prove challenging and competitive, so some businesses may turn to investment bankers, brokers, and other financial experts to help connect them with potential equity investors. These intermediaries don’t supply capital themselves but have a wide network of experts and investors that specialize in specific industries or types of transactions, such as initial public offerings (IPOs).
The Bottom Line
Understanding the various sources of capital available to businesses could be important for making informed financial decisions and achieving long-term success. Business capital comes in many forms, but some of the most common types are retained earnings, debt financing, and equity financing. Each capital source has its own advantages and risks that vary by business stage and industry. By carefully evaluating all available options and selecting the most appropriate funding mix, businesses could help effectively manage their financial risks, fund their operations, and seize growth opportunities to help build a more stable and financially stable future.
What Is Working Capital?
While getting funding may not be easy, understanding how to effectively utilize your existing capital presents its own challenges as well. Learn more about managing your working capital here: What is Working Capital?
A version of this article was originally published on June 08, 2015.
Photo: Getty Images
The material made available for you on this website is for informational purposes only and is not intended to provide legal, tax or financial advice. If you have questions, please consult your own professional legal, tax and financial advisors.
Terms and Conditions
1 American Express® Business Line of Credit offers access to a commercial line of credit ranging from $2,000 to $250,000, although some customers may have access to a larger line of credit. Decisions regarding the line of credit amount, loan fees and available installment term options are based on a review of your and your business’s overall financial profile, which may include your credit history, your relationship with American Express and other financial institutions, and other factors. The line of credit amount, loan fees, and installment term options are each subject to review and may change for future loan activity. A review of the line of credit may result in a suspension at any time, accompanied with or without a closure of the line of credit. Not all customers will be eligible for the lowest loan fees or all installment options, and not all industries are eligible. All loans are subject to credit approval, are secured by assets of the borrower, require a personal guarantee, and may be subject to late fees. Loans are issued by American Express National Bank.
Each draw on the line of credit results in a separate installment loan with monthly installments which may include 6, 12, 18, or 24 months, subject to eligibility. When you request a loan, you will be presented with the available installment option(s) and the monthly loan fee for that loan amount. The monthly loan fee is calculated as a percentage of the original principal amount of the loan and is charged monthly during the term of the loan along with a portion of the principal. Currently, the monthly loan fees may range from 0.55% to 1.55% of the original principal amount, but the loan fee offered to you for future loans may change at any time. You will be charged monthly loan fees only for months in which the loan has an outstanding balance.
If you repay the total principal of a loan early, you will not be required to pay the loan fees that have not posted for subsequent months. American Express may offer promotions and may reduce or waive loan fees from time to time.
