Looking at long term sources of finance: All you need to know about equity shares…

A business has various sources of raising funds. Raising funds through debt and preference shares is quite common but one of the most popular and important sources of long term finance is raising money through equity shares. How exactly does a company raise money through equity shares and what is the impact on the balance sheet when it raises money through the issue of equity shares?

Raising long term finance through IPOs…

Initial public offerings (IPOs) are a popular method of raising long term finance for companies. Normally, in an IPO an unlisted company issues fresh shares to the public. The IPO goes through a typical process of identifying the book running lead managers to manage the issue, fixing the indicative price for the IPO, running the book building issue, finalizing the basis of allotment, actually allotting shares and finally listing the equity shares on the stock exchange. When a company comes out with an IPO the share capital of the company expands and the earnings per share of the company gets diluted. IPOs are quite popular as an investment option among retail and institutional investors.

Using a combination of IPOs and offer-for-sale…

Another popular method of raising long term finance is a combination of an IPO and an offer for sale. In this issue, the actual issue is a mix of fresh issue and sale of shares by existing shareholders. Normally, the OFS is used to give an exit route to existing institutional shareholders like institutions, anchor investors, PE investors etc. At times, the promoters may also divest part of their equity stake through these OFS as we saw in the case of issues like Narayana Hrudayalaya. Remember, that the IPO leads to dilution of equity but the OFS does not lead to dilution of equity as it merely results in transfer of shares from one owner to another.

Ploughing back profits as a source of fund raising…

This is also a form of raising funds for the expansion of the business. When we talk of ploughing back we are referring to the use of the company’s own resources for long term finance. What does the company do out of its post tax profits. Of course, part of the post tax profits will be used to pay dividends to shareholders. The balance is transferred to the reserves of the company and that becomes a very important source of long term finance for the company. Consider the Balance sheet of Infosys below…

As can be seen from the above balance sheet of Infosys for the quarter ended March 2017, Infosys is a virtual zero debt company. But it has accumulated a huge reserve position (classified as Other Equity) which is almost a 60X multiple of the equity share capital. These reserves have been built up through ploughing back of profits made year after year. In case of Infosys the underlying business philosophy has been to rely on internal accruals rather than on external funding. Here is an important point to remember. When you plough back profits and create reserves, it does not impact your EPS or your P/E ratio. But it does impact your Return on Equity (ROE) since your equity is a summation of your share capital and free reserves.

Raising long-term funds through Rights Issues…

Another form of raising funds is through Rights Offers to existing shareholders. A rights issue is not opened to outside shareholders but only to existing shareholders of the company. Rights issues are typically issued in a fixed ratio. For example, rights issue in the ratio of 3:5 means that the existing shareholders will be offered 3 shares for every 5 shares held for them. Therefore a shareholder having 1000 shares will have to right to buy 600 shares at a predetermined price. Normally, the rights price is fixed below the market price to make it attractive to existing shareholders. The shareholder may or may not exercise the right to purchase these shares in which case it may be issued to others.

Raising funds through Follow-On offers…

A follow-on offer is just like in IPO, the only difference being in a follow-on offer the intent is not a new listing since the shares are already listed on the bourses. The follow on offer helps the company to raise additional funds in the market and also expand its shareholder base. Follow on offers also lead to dilution of equity shares once the new set of shares also get listed on the stock exchange.

Equity shares are an important source of long term finance. Here are 3 points to remember…

  • Equity as a source of funds has a cost and in fact the cost of equity is higher than the cost of debt. Cost of equity is normally defined as the rate of return that is required by shareholders to invest in the shares.
  • Any kind of equity fund raising will lead to dilution of equity. It may happen in either of the forms. Either it may lead to dilution of EPS or it may lead to dilution of ROE, as in the case of ploughing back earnings.
  • When a company raises money through equity, it is shown in the liabilities side of the balancesheet as it is what the company owes to the equity shareholders.

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