The three forms of financing and their relative importance to major U.S. corporations.
Companies can generate assets from three sources: (1) borrowings, (2) issuing equity securities, and (3) retaining funds generated through profitable operations. Borrowings are represented by liabilities on the balance sheet, equity issuances are represented by contributed capital (preferred stock, common stock, and additional paid-in capital), and retaining funds are represented by earned capital (retained earnings). Major U.S. corporations generally rely more heavily on liabilities as a form of financing than on the combined total of contributed and earned capital. Earned capital is typically more important than contributed capital. The additions of contributed and earned capital represent the shareholders' investment in the company.
Distinctions between debt and equity.
Debt involves a contractual relationship with an outsider. The contract usually states a fixed maturity date, interest charges, security in case of default, and additional provisions designed to protect the interests of the debtholders. Interest is an expense on the income statement and is deductible for tax purposes. In case of liquidation, creditors have rights to the company's assets before owners. Creditors ...