This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
The capital funds used in business enterprises fall into two classes, "owned funds" and "borrowed funds." In an individual proprietorship or in a partnership the distinction is clear and easily made. The total value of the assets of such a business is represented on the liability side of the balance sheet, first by obligations, or "borrowed funds," and secondly by proprietorship, including whatever surplus has accumulated.
In a corporation the distinction between "owned" and "borrowed" capital is not always so clear, nor is it so vital. The corporation itself owns all of its assets and owes not only its obligations; but also its capital stock and surplus. The creditors and the shareholders of the corporation hold varying amounts and degrees of claims against the corporation which almost imperceptibly shade into each other. The distinction between debenture bonds and certain types of preferred stock is slight. Indeed, it would be difficult to name any dividing line which clearly separates the shareholders from the obligation holders, or creditors, of a corporation.
Nevertheless, we may in general follow the customary line of distinction and say that most bonds, notes, accounts payable, and other obligations of a corporation, may be regarded as representative of borrowed capital, and most shares of capital stock may be regarded as representative of owned capital.
Some companies have practically nothing but owned capital; that is to say, their borrowings are almost nil. Ordinarily, the only corporations in this condition are those which have just started, or those which are small and struggling and have not the credit which would enable them to borrow even on short time. Once in a while, however find a large corporation which follows the same policy. For instance, the W. L. Douglas Shoe Company carries on the liability side of its balance sheet only common stock, preferred stock, and a small amount of current accounts payable.
A small enterprise is usually conducted on the owned capital of the proprietor or the partnership, with possibly recourse to the bank for short-term loans from time to time. Also, the proprietor or one of the partners will sometimes, borrow money for the business on his personal note, secured perhaps by mortgage of his real estate, and thus increase his investment and the amount of the partnership's owned capital by the amount so secured.
When there is a single proprietor, he may perhaps, when additional capital is required, secure this by the admission of a partner with capital A partnership might accomplish the same result by adding another partner. It is possible at times for firms to secure additional capital by admitting special or limited partners, who take no active part in the business but who invest capital and share In the profits. In many states the statutes. provide that the speicial or limited partner shall not he liable to creditors of the firm beyond his investment. When the statutes do not provide for limited partnership , the same end may be accomplished by admitting a dormant, silent, or Sleeping partner. The dormant partner takes no part in the business, and usually avoids publicity as to his connection with the business. if known to be a partner, he may be held for the partnership obligations, like any other member of the firm.
It is, of course, always possible for a sole proprietorship or partnership to incorporate and issue stock; if it does so, its capital problems are then the same as those of any other Corporation Many small businesses have been incorporated, and most businesses when they increase to a certain point incorporate, on account of the facility given by the corporate forms in securing additional capital.