Equity: Its Purposes & Sources
December 10, 2009, 10:34 pm
Copyright © 2009 Integrated Profitability TM
Capital has two main purposes:
● an initial one and
● an ongoing one
Initially, capital is the seed-money to finance the launch of a new business. New ventures begin with nothing and need funding. This capital can come from any source, such as personal savings, private investors, venture capitalists or the proceeds of the issuance of shares of stock. Each source will demand some sort of compensation for advancing funds. The most common is an equity stake in the new company.
For corporations, ownership is denominated in terms of a specified number of shares. Each of these shares is given a par value, usually $1.00. These shares are them offered to financial markets for purchase and investors bid on them based on their estimates of the overall value of the business concept embodied in the company. Investors pay for the shares with cash that is the seed money for the new venture.
This initial infusion of cash (the balancing entry to the capital invested) allows the new business to fund its activities, bring its products & services to market, and start attracting customers, sales and the beginning of an ongoing business. As “Capital Structures: Market Examples & Other Names for Capital” showed, this capital consists of Common/Preferred Stock (at par value) and Capital in Excess of par value.
Assuming the new business is successful, any annual positive profit that is poured back into the company is booked into the “Retained Earnings” account in the capital section of the Balance Sheet. As long as the business is growing, is consistently profitable, and
profit is re-invested in the business, then the “Retained Earnings” account will continue to increase.
At this point, when the company is an ongoing commercial venture, the purpose of capital is to act as a buffer to absorb any downturn in the business. Risks are inherent in all business activities. It is important to identify them and then gauge the probability of their adversely impacting the company.
If the company suffers difficulties large enough to cause a loss in the Income Statement, then accumulated “Retained Earnings” are used to absorb that loss. Therefore, the more capital a company has, the larger a loss it can handle. Likewise, if the market hits a longer term business downturn, larger capital accounts allow companies to weather losses for a longer time.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 46
Telephone: 925-202-6244
Copyright © 2009 Integrated Profitability TM
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