Capital is defined as money invested in a business to purchase assets, and the process used to raise capital is critically important for a company owner.
Every business needs cash to purchase assets, hire employees, and to pay for marketing costs. An owner can raise capital by issuing stock, borrowing money, or a combination of both methods.
Balance sheet components
A balance sheet provides detail for these categories:
- Assets: Assets are defined as resources that are used to generate revenue (sales) and profits in the business. An asset may be tangible, such as a vehicle, or intangible, such as a patent or other intellectual property.
- Liabilities: Liabilities represent amounts owed to other parties, including accounts payable and long-term debt.
- Equity: Equity (also referred to as stockholder’s equity) is the difference between assets and liabilities, and equity includes common stock, additional paid-in capital, and retained earnings. The equity balance is the true value of a business.
The three components of the balance sheet are driven by the balance sheet formula:
Assets – liabilities = equity
A firm’s capital structure is defined as the percentage of total capitalization that was raised by issuing stock vs. debt. If a company issues stock, the purchases are owners (shareholders), while purchasers of debt are defined as creditors. Each type of stakeholder creates a different set of expectations for the issuing company:
- Shareholders: Stock purchasers are owners of the business, and these owners typically have the right to vote on major corporate decisions, such as a company merger or sale. Many firms reward shareholders by paying a cash dividend out of company earnings, and shareholders can also benefit if the business performs well and they can sell their shares for a gain.
- Bondholders: The most common form of debt issued is a corporate bond, and these bonds pay interest twice a year. The issuing company is obligated to pay interest each year, and to repay the face amount (principal amount) of the bond when the bond reaches maturity. Corporate bonds trade on exchanges, just as stocks do, and the investor can sell the bond before maturity.
The capital structure of a firm can vary greatly, depending on the company’s ability to generate consistent earnings. Businesses that generate profits each year are more likely to issue debt, because they can make interest and principal payments on a timely basis. On the other hand, firms that don’t generate consistent earnings must issue equity.
An example, assume that an auto parts manufacturer issues 5,000 shares of $10 par value stock for $35 per share. Par value is an accounting term that is used to value each share of common stock posted to the balance sheet. The dollar amount above $10 par value per share is posted to additional paid in capital. The manufacturer also issues $150,000 in 5% corporate bonds due in 10 years.
Here is the dollar amount of capital raised by the manufacturer:
$150,000 5% corporate bonds due in 10 years
$50,000 Common stock (5,000 shares of $10 par value stock)
$125,000 Additional paid in capital (5,000 shares at $25 per share)
$175,000 Total shareholder’s equity (5,000 shares at $35 per share)
Long-term debt is 46% of the capital structure, and equity is 54% of the total.
Assume that your furniture manufacturing raises capital by issuing stock. Your firm issues 100,000 shares of $10 par value stock for $28 a share. Par value is an accounting term used to assign a value to common stock in the balance sheet. In this case, the common stock balance is (100,000 shares X $10 par value = $1,000,000 common stock).
Additional paid-in capital (APIC) is the dollar amount received from issuing the stock that is greater than the par value. The dollar amount received is (100,000 shares X $28 issue price = $2,800,000), and APIC is ($2,800,000 – $1,000,000), or $1,800,000.
Retained earnings is the sum total of all prior net income earned by the firm, less any cash dividends paid to shareholders since inception. In this example, assume that the beginning balance of retained earnings is $500,000, and $40,000 in February net income is added to the balance. The equity section of the balance sheet is:
Additional paid-in capital$1,800,000
To keep the balance sheet formula in balance, assets less liabilities must equal $3,340,000. If not, there is at least one error in the accounting records.
Liquidity vs. solvency
The balance sheet is used to generate many financial ratios to make business decisions, and two important analysis concepts are liquidity and solvency. Liquidity measures a firm’s ability to produce enough current assets to pay current liabilities. The term solvency refers to a company’s ability to generate enough sales and profits to purchase expensive assets and pay down debt over the long term. Financially healthy businesses must address both liquidity and solvency.