If a company wants to grow and expand, it needs money. Money is often needed to buy land, machines or hire additional employees etc. The money (known as capital) needed depends upon how much the company needs to invest for expansion. If the money required is small, the company might afford it. However, if the money required is very large and the company feels that it does not have sufficient resources, it has to borrow money.
Now the company has two options for raising capital:
Case 1: Take a Bank Loan
Case 2: Take money from the public (by issuing shares)
Let us briefly see what happens in each case.
In case 1, the company goes to a bank and applies for a loan. The bank analyses and evaluates the company. If the bank is satisfied with the company’s performance, and has sufficient reason to believe that the company will be able to repay the loan amount, they approve the loan at a certain interest rate. Thus the company gets the loan to expand its business.
The problems in this case are:
The interest is very high
– Interest rates usually exceed 10%. Usually, companies do not want to pay a huge sum as interest.
What if the business makes a loss?
– Even if a loss occurs, the company has to return the loan amount with interest to the bank- an additional burden.
Risk of facing legal action
– If companies make a big loss and are unable to repay the debt from banks, they may face legal action. After the introduction of the Insolvency and Bankruptcy code, the laws for loan recovery have become very strict.
Banks may refuse to grant the loan
-If the company requires a large sum (example Rs 1,000 crore) then banks may refuse to give such a big amount.
Thus, there are certain risks and headaches involved in taking loans from banks. However, there is another alternative.
If the company feels that taking a loan is not a good idea (due to any of the reasons listed above), it may consider Case 2. For raising money from the general public, the company releases its Initial public offering or IPO. IPO is the first time a company is listed on the stock markets. It is the first time that the shares of the company are available to the public.
People who buy shares are called Shareholders. Let us talk about it a little more.
The name ‘Share’ indicates “a part of something” and interestingly, it really means a part of the company. Shareholders ‘share’ the profits or losses that a company makes. When you buy shares, you are purchasing a part of the company! Isn’t this exciting?
Let’s say that a company has 100 shares and you buy all of them. You become the owner of the company. Likewise, if you buy 10 shares, you own 10% of the company and so on.
If the company in which you invested your money uses the shareholders money wisely and expands its business, it earns more money. As a consequence of increase in profits, the value of the shares increases. Therefore, you also earn profits if you sell the shares.
Other than by selling, you can earn if the company announces a dividend to reward the shareholders. We shall talk about dividends in another article.
If you had invested rupees ten thousand in Infosys when it first issued its shares to public in 1993, you would have earned more than Rs 4,00,00,000 (that’s 4 crore!) by now.
But beware! Stocks are not lottery tickets. They represent actual ownership in a company. You should get yourself educated before even thinking about buying them.
If you have any questions, please ask them in comments below and I will answer them to the best of my capability. Keep reading keep learning.