Let’s start with the basics. Every company needs capital to run a profitable business. The company can raise this capital by choosing between two options. The first option is to have equity and the second option is to capitalize the company by borrowed capital. When raising the capital the company operates in the financial market. The financial market is a market where companies can trade for example stocks, bonds and commodities. The financial markets can be divided in two parts that are the capital markets and the money markets. The capital market is for long term finances and the money market is for short term finances.
Just to be clear the financial markets have four main functions:
- Allocate funds between surplus- and deficit sectors
- Transfer the liquidity
- Transfer the risk
- Provide information
Let’s take for example a bond. It’s a debt in which the issuer owes the holders a debt and is obliged to pay them interest and to pay the principal at a later date. Bonds provide the borrower (the issuer) with external funds which can be used for example to finance long-term investments. The good thing about being a lender (the one who hold the bond) is that in case of bankruptcy the lenders will be repaid before the stockholders.
Another way for the company to raise money is the stock markets. At the stock markets stocks are listed and traded. People can buy holdings from a company by buying its stocks. We can discuss – from the view of the company or the investor – if it’s profitable to raise the capital by equity or by borrowed capital and what is the price for the company.
Let’s get back to the financial markets and the view of company for a second. As I mentioned earlier the companies have to pay rent for the borrowed capital. This rent depends on how high the risk is. It is also good to remember that companies have to pay back the borrowed capitals. Secondly if a company has a profitable financial year it can pay dividend for investors. Including this equity financing gives decision-making to the shareholders.
In the end the only sustainable thing is that companies have to have capital for running business and it depends on the company which is the best way for them to get it.