I have been very fortunate to have worked in a variety of sectors and businesses during my working life.
This has given me a great opportunity to understand many different funding options and I have long been fascinated by the process of optimising capital to assist in driving strategy. This is what I have learned about the importance of capital structure.
An appropriate capital structure is an important strategic pillar to support growth and ensure adequate liquidity for operating a business – it definitely helps you play the long game. Its importance is amplified in times of crisis – witnessed over the last 25 or so years including the Asian Financial Crisis, the GFC and current COVID-19 crisis. It sounds complex but is very straightforward – it is driven by a clear strategy and includes key financial elements of cash flow, interest rates, currencies, liquidity and an assessment of financing options.
Critical to running and growing a business is creating a clear strategic roadmap incorporating your vision, values and plans. At Straight Bat we use a simple but highly effective tool called a 1 page strategic plan (1PSP) – ironically a 2-page document – you can access our home grown example here Straight Bat 1 Page Strategic Plan or 1-Page Strategic Plan (5 minute read).
The output from a 1PSP details time-based goals and tasks to achieve your plans. This will inform the funding requirements for the business. The next step is to build a 3-way Financial Model. It will forecast and link the Profit & Loss, Balance Sheet and Cash Flow statements over the term of the 1PSP. The Financial Model should incorporate assumptions that reflect the opportunities and risks the business faces including:
- Acquisition and market expansion opportunities
- Interest Rates and Exchange Rates
The model creates a numerical picture of the business’ potential and an understanding of the potential variability of profits, assets, liabilities and cash flows. Sensitivity analysis can be undertaken to understand how vulnerable your targets are to fluctuating market conditions. Importantly the Financial Model should be structured to show the capital required to finance the planned growth. At a high level the sources of capital are self-generated cash, debt and equity. As the following table illustrates, company objectives will have a fundamental impact on the financing arrangements considered:
| Objective | Considerations |
|---|---|
| Minimise equity dilution and maximize control over the Company | • Minimise use of external equity • Maximise use of self-generated cash • Maximise use of debt |
| Minimise risk of bankruptcy | • Maximise use of self-generated cash • Maximise use of external equity • Minimise use of debt |
| Minimise the overall cost of capital | • Minimise use of external equity • Minimise use of self-generated cash • Maximise use of debt |
| Ensure there is sufficient capital available to execute the Strategy | • Optimise the use of external equity, self-generated cash and debt • Size debt within target credit metrics |
The ultimate financing structure will be determined by a variety of factors. This will include the risk profile of the owners, the company’s lifecycle stage, its current financial structure, the industry within which the company operates and its financial performance.
In deciding where to source growth finance the following factors are typically important:
| Factor | Considerations |
|---|---|
| Returns | If the finance is self-generated then it is effectively raising equity from current shareholders so appropriate risk / return analysis should be performed. |
| Risk | Understand contractual payment obligations attached to the finance and incorporate target gearing / credit ratings / debt service coverage to ensure obligations can be met. |
| Availability | Develop an understanding of the availability of capital in different markets and the style / term of commitment. |
| Control | Additional equity may dilute / alter the control and other rights of existing shareholders. |
There is no single “right” financing solution for any business. The best sources of finance will be those that are committed for the term of the strategy, match the owners’ risk profile and are able to deal with modelled levels of variability in financial and strategic outcomes.
A couple of examples:
- As CEO of a transport business – we had a fleet of ~400 trucks & vans – and the business was growing rapidly. We utilised the equipment finance market as the key funding solution. It is a very deep, liquid and efficient market. It is also very effective at funding a growing business. This market was also complemented by the retained earnings and equity cash flows of the business
- As a banker to several large Australian businesses I was deeply involved in assisting growing businesses use multiple markets including the domestic banking market, domestic institutional debt market and the long-term US debt market. The blend of markets creates competitive tension, a range of maturity terms and creates a diverse capital base – again complemented by equity.
Articulating the strategy, building a financial model and then assessing how to best fund your organisation is a great way to enhance the success and longevity of your business. It gives you the confidence to have a crack and play the long game in Straight Bat vernacular. It is also an enjoyable and fun process. Give me a call if you would like to know more.
