Question

Why can firms not just use their own profits for financial capital, with no need for outside investors?

Short answer

In conclusion, firms cannot solely rely on their own profits for financial capital due to several limitations such as business growth, cash flow management, risk management, and increasing credibility and valuation. Outside investors provide additional financial capital, expertise, networks, and industry knowledge that is crucial for businesses to overcome these limitations and achieve their goals more effectively.

Step-by-step solution

Understanding financial capital

Financial capital refers to the funds that businesses use to acquire assets, pay off debts, and finance various operations. Firms generate financial capital from several sources, including their own profits and outside investors. Using a company's profits is referred to as internal financing, while involving outside investors is known as external financing.

Identifying the limitations of using only profits for financial capital

There are several reasons why relying solely on profits for financial capital may not be feasible for businesses: 1. Business growth: A company might have ambitious growth plans that can only be achieved by having access to a larger pool of resources than what their profits can provide. External financing allows businesses to acquire the funds required to finance expansion, research and development, and other growth opportunities. 2. Cash flow management: Profits may not be consistent or sufficient to cover a company's immediate financial needs. By seeking external financing, companies can ensure they have steady cash flow and can meet their financial obligations in a timely manner. 3. Risk management: Solely relying on profits exposes a company to financial risks in case of an economic downturn or decreasing profitability. External financing can help mitigate these risks by diversifying the sources of financial capital available to the business. 4. Increased credibility and valuation: Attracting outside investors can demonstrate the company's attractiveness and potential for future growth, leading to increased credibility, brand value, and potential for further investments.

Explaining the role of outside investors

Outside investors play a crucial role in providing financial capital to businesses. They bring in funds that the firm can use to finance its operations and growth strategies. Moreover, they may bring valuable expertise, networks, and industry knowledge that can contribute to the company's overall success. In return, investors often receive a share of ownership in the company, which could generate profit for them through dividends or eventual sale of their equity stake.

Concluding the argument

In conclusion, while a firm's profits can be a source of financial capital, relying solely on them may not be sufficient or practical for various reasons like business growth, cash flow management, risk management, and increased credibility and valuation. Outside investors provide additional financial capital, allowing businesses to overcome these limitations and achieve their goals more effectively.