FINANCIAL  MANAGEMENT

 

 

Issue

 

When we need more capital to fund the acquisition of resources necessary to expand our markets, or increase the products or services we supply, or simply to cover the increasing operating requirements as our organisation grows, we can cast our net wider in search of the necessary funds. Whether we take in additional equity capital, or look to finance our growth with debt finance, the investors we approach will need to be sure that our organisation represents a sound investment for them. An organisation's finances and its operations are integrally connected. Our financial structure is fundamentally shaped by our activities, methods of operation and competitive strategy. The reverse is also true. Decisions that appear to be simply financial in nature may significantly affect our operations. This is particularly appropriate when we are considering the source of additional capital and we must do all we can to ensure we maintain a balance that is in the best interests of our organisation. What should we consider when making that decision?

 

Solution

 

Selecting the most suitable mix of debt and equity is a two-step process. The first step is to decide on the amount of money we require. If we do not believe we can raise the sum required on agreeable terms, then we need to modify our plans to curtail operations within the funds available. The second step requires careful consideration of financial markets and the terms on which we are able to raise the additional capital that we need. Whether the source is debt, equity, or a mix of both we have a tremendous variety of options available to us. Our choices are vital and are at the heart of the financing decision. The proper choice will provide our organisation with needed cash on attractive terms. An improper choice may result in excessive costs, financial discomfort, and undue risk to the viability of our organisation.

 

In recent years, as organisations have sought to exploit the advantages of each form of capital without incurring the disadvantages, the differentiation between debt and equity has become increasingly blurred by the development of hybrid forms of finance, such as warrants and convertibles. So, when deciding on the source of any new finance there are several important factors that we need to take into account. These are:

 

• the administrative and legal costs of raising the finance

• the cost of servicing the finance

• the level of obligation to make interest or similar payments

• the level of obligation to repay the finance

• the tax deductibility of costs related to the finance

• the effect of new finance on the level of control of the business by its existing owners and on their freedom of action.

 

If we require more capital to finance our activities but don't want to raise additional equity, we really have only two alternatives: we can sell some of our assets or we can borrow. Borrowing has a major drawback – if we fail to meet the agreed terms of our loan, especially a scheduled interest payment or principal repayment, the lender may take legal action to force repayment of the outstanding balance of their loan. Apart from causing financial distress, the taking of such action is likely to harm our reputation. Quite clearly, if we have large amounts of debt we run the risk that, in a bad trading year, we may be forced into insolvency. Looking at this more positively, debt finance is always cheaper than equity finance because lenders assume less risk for exactly the same reason that it is a drawback for the borrower – there is a contractual obligation to repay principal and interest. Also, there are major benefits that we can enjoy through borrowing, which include:

 

• it is relatively cheap to raise funds by borrowing. The loan can be syndicated among several banks and other lenders who, by spreading their risks, can offer lower interest rates.

• interest payments are tax deductible, although this is of value only if we happen to be tax-payers. The ability to set interest payments against profit for tax purposes creates a significant financial benefit.

• use of debt also imparts a leverage effect where an increase in activity will have a more than proportionately favourable impact on our profit.

• an issue of new equity risks altering the balance of voting control. Debt carries no voting rights therefore the only lessening of control is imposed by the inclusion of restrictive covenants, such as stipulations of minimum liquidity levels or maximum dividend payout ratios, or restrictions on further borrowing, in the loan agreement.

 

When, as part of raising funds for its operations, an organisation decides to borrow money the question that is asked first is how long should we take the loan out for? Should we be looking to repay the debt in one year, 5 years or even longer? To answer this question, we should understand the reasons why we need the money. If it is for day-to-day operations, then we should consider a short term. If, on the other hand, it is to acquire long-lived resources then we should be thinking of a longer term.

 

In the context of our entire capital structure, the minimum risk maturity structure occurs when the maturity of liabilities is the same as that of our resources. If we take this position, the cash generated from operations over the coming years should be sufficient to repay existing liabilities as they mature. If the maturity of our liabilities is less than that of assets, then we are faced with a refinancing risk because we will not generate sufficient cash from our resources and so we might need to use some of the proceeds from new capital raisings to repay existing debt. The problem here is that there is no guarantee we will be able to raise new capital!

 

If the reverse were true, that is the maturity of liabilities is greater than that of resources, cash generated from operations will be more than adequate to repay existing liabilities as they mature. Unfortunately, while this approach provides a margin of safety, it may leave us with surplus cash for which we are unable to find a suitable use. If maturity matching is minimum risk, why do anything else?

 

We have a wide choice of financing options and choosing the right ones for our needs is essential. Most organisations use a combination of these alternatives, according to their specific needs and circumstances. Of course, apart from looking to external sources for additional funds, we are able to raise funds, both short- and long-term, internally from our cash flow. From a long-term perspective, keeping earned profit in our organisation really helps when it comes to funding needs. Looking at the short-term, the control of cash and the selection of an appropriate working capital strategy will help prevent unexpected cash problems. The choice is ours. We just have to make sure that we find the most beneficial and prudent balance between debt and equity sources of funds that provide us with the lowest possible cost of capital to go forward with our bright ideas!