I have a very basic fundamental question about this topic.
On page 78 of the Corporate Finance book, Reading 33 Cost of capital, it is said:
“The company acquire the capital or funds necessary to make investments by borrowing or using funds from owners”
This is clear to me. However. Why does a company not use the profit it gets from its operations to fund its investments instead of debt/equity? This net profit should be also a source of “free” cash to fund investments, right?
Shouldn’t then the company have 3 sources of capital? Debt + Equity + Profit from operations?
If I were a company, I would make use of this profit I get from running my business as a first source of cash to be reinvested in my company for future projects. And only if I don’t have enough I would try to get financed from debt or equity.
Would you mind elaborating a bit? I understood the net profit the company has is the excess revenue after all costs, interests, depreciation, taxes, etc… so it must be the extra cash the company generated, right?
No, because accounting profits (eg, net income) are recorded on an accrual basis. For example, when a company sells $100 of goods to a customer on credit that’s payable in 30 days, the company will record $100 in revenue, and $100 in accounts receivable. That $100 will increase profits (after considering expenses and taxes) but is not an actual cash flow. Therefore you have to back the change in AR out of profits to get cash flow. Does that make sense?
Thanks both for your answers! Really appreciated it.
S2000magician, maybe is retained earnings what I meant without knowing it retained earnings is the extra cash after the company has fulfilled all their obligations. This amount is then either distributed with the shareholders, or reinvested in the company itself, right? The company can do whatever it wants with that money. So why then would try to raise costly capital to fund a project if it already has it?
In this case, the source of capital for a project is neither debt nor equity, is the extra cash the company has, with in this case, is for free for the company. (?)
Thanks again for helping me understanding the big picture!
Mr. Padilla, what accounting course(s) did you take in college, if you don’t mind me asking? (Once I have your answer to that, I’ll offer some thoughts about accounting, esp. the accrual basis vs. the cash basis.)
I look forward to having a ‘conversation’ with you about the questions you’ve asked.
You may also be able to think of it this way - Net income ultimately flows into retained earnings and retained earning is part of equity. So you really only have your equity or debt as sources of funds.
Additionally, another reason companies use “costly” debt is because it can be cheaper than paying dividends, especially with rates so low!
As you probably have noticed, I didn’t take any accounting courses in college. I have a degree in computer engineering. That’s why these topics are more or less new to me and some difficult to grasp
With the net income that flows into retained earnings (which is part of equity), a company could finance projects with that capital “for free”, without the need to raise debt or more equity.
Juan, Retained Earnings has nothing to do with Cash. Nothing whatsoever. If an analyst is interested in Cash, which, IMHO, all analysts should be, the place to look is at what, in my professional opinion, is THE most important component of the financial-statement package: The Statement of Cash Flows (SoCF).
Unfortunately, there are two ways to present the SoCF: the ‘direct’ basis and the ‘indirect’ basis. The latter is far more common, and that’s really unfortunate because, for most non-accountants, that presentation might as well be in Swahili. The direct method of presenting the SoCF is really easy to understand because it’s simple, logical, and obvious. Most important, the reader needn’t have a strong background in accounting to understand it.
It also tells those who run the company a lot of useful information that the indirect method does not: specific sources and uses of cash.
However, as the indirect method is essentially required under both US GAAP and IFRS, and as the resulting CFO will be the same under the direct method as it is under the indirect, and as most people are intrinsically lazy, roughly only 2% of companies use the direct method.
I agree 100%. I suspect the 2% figure results from the GAAP requirement to present the Indirect Method, too, when the Direct Method is used. That requirement makes zero sense to me. If anything, it ought to be the other way around.
retained earnings is the extra cash after the company has fulfilled all their obligations. This amount is then either distributed with the shareholders, or reinvested in the company itself, right? The company can do whatever it wants with that money. So why then would try to raise costly capital to fund a project if it already has it?