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Strategic framework for financing your business.

Your business' assets must be purchased, or funded, somehow. Buy equipment and you have to buy it outfight using equity or obtain financing (i.e., debt). Sell on "terms" and you have to cover the cash delay by some means. Buy inventory and--assuming your credit is acceptable--you're likely able to obtain interest-free payment terms (i.e., trade credit). But most companies cannot turn their inventory into cash quickly enough to completely finance inventory using trade credit, so the gap must be funded with some combination of interest-bearing debt and equity

In deciding how to fund your business, you should use the least expensive and inhibiting means. The cheapest is trade credit. Once trade credit is exhausted, interest-bearing debt tends to be the next cheapest. But the business owner must not lose sight of the fact that borrowing (i.e., leverage) adds financial risk. The higher the leverage, the higher the risk of default.

Risk can be generalized to refer to volatility of earnings. Companies with very predictable earnings can afford to use higher levels of debt. Companies with unpredictable earnings have, of course, a higher degree of uncertainty in predicting their ability to meet fixed obligations and, therefore, a lower tolerance for debt. Business owners must balance their desire for ROE-boosting benefits of debt with their own personal tolerance for risk and the business' unique ability (or inability) to safely handle it.

Evaluating funding options, many criteria should be considered. Here are a few.

Cost: The rate of interest charged on debt is the most visible cost of debt financing, but there are other costs and considerations. First, the effective cost of debt financing is lower than the nominal cost because interest expense is tax-deductible. Costs of equity capital are not tax-deductible. Second, origination fees may accompany debt and equity financing. Third, time is a very important dimension, and raising equity financing can be very time-consuming--both to secure and maintain.

Repayment terms: Debt financing always has repayment terms. It is critical that the terms match the use of funds and/or the cash flow cycle of the business. More flexible terms, such as interest only and longer maturity dates, reduce risk. Equity capital typically is the least risky because it has no repayment terms or obligations.

Restrictions: The beauty of equity capital is that it comes with few restrictions. Debt capital often comes with certain covenants that restrict the actions of management. These restrictions serve the purpose of lowering the risk borne by debt providers to a level acceptable to them and that conforms with their lending parameters. The borrower should consider the true cost of these covenants when choosing funding options.

Control: Substantial powers and benefits accrue to the controlling owners of a company, and controlling interests tend to trade at substantially higher values than non-controlling interests. For this reason, controlling owners should seek to maintain control and minimize risk of losing control. Raising debt and equity capital can bring to the fore scenarios that could cause partial or total loss of control. Such risks should be carefully assessed by the owner when choosing capital alternatives.

Personal Financial Risk Business owners choose the corporate form as a means for shielding themselves from personal financial risk. But lenders of debt often require personal guarantees from controlling owners. The purpose is to bring the lender's level of risk down to a level that is acceptable and in line with lending policy. Business owners should consider all of their capital options and rationally decide which risks to bear, to what extent, and for what period of time.

With these criteria in mind, we offer the following framework for making your capital decisions:

> Strategy Imperative # 1--Maximize Return on Assets: One of the most basic barometers of business performance is return on assets. This is simply the amount of profit earned from a given dollar value of total assets. In a competitive marketplace, the goal must be to maximize return on assets. That is, getting as much profit as possible from the smallest amount of assets. This is also referred to as asset utilization. As the business owner makes capital decisions, the first strategy should always be to figure out how to get more from less. And because assets must be funded with either debt or equity, minimizing assets will lower the capital requirement--and the capital cost that must be incurred to generate a given level of profit.

For ideas on reducing the amount of assets your business requires, see the accompanying article, "Harvest Cash, Improve Returns by Reducing Assets".

> Strategy Imperative #2--Use the Least Costly Capital Source: In addition to the ongoing search to lower the required amount of assets (i.e., improve efficiency), the owner should seek to fund the required assets using the least costly source. Clearly, trade debt is the cheapest. It often comes with little or no cost (remember that it might not be free in light of such things as early-pay discounts) and rarely requires collateral, operational restrictions or personal guarantees from the owners.

Once trade debt is maximized, the options turn to interest-bearing debt. Credit cards could be considered a low-cost form of interest-bearing debt if the balance is paid off monthly Traditional bank borrowing is the primary form of interest-bearing debt, and for the healthy business it's readily available. Working capital financing is often the least costly and lowest risk because it is secured by assets that will quickly turn to cash--receivables and inventory.

Equity capital is considered the most costly form of capital bemuse it is the most risky This is primarily because equity holders are the last to get paid. That is why it is referred to as "a residual interest in the assets of the business." In a private company, it is also very risky because it is highly illiquid. To be sure, equity interests in private companies are difficult and expensive to sell.

Wondering how equity can be so much more expensive than debt when it does not require any debt service payments? Consider what you would have to offer investors to entice them to contribute equity into your business. Likely, it would be very difficult unless you GUARANTEED them terms that you yourself don't enjoy These "extra" terms would deem their stake to be superior to yours and thus would classify their share as preferred stock or stock with convertibility options such as warrants. In short, you'd have to offer quite a rate of return, and provide terms that lowered their risk or offered liquidity to entice any investor to contribute equity into your business. It is sobering to note that you also should be earning a healthy (25% or greater) return on your equity investment in the business--given the risk you bear each day

> Strategic Imperative #3--Maximize returns. A business that does not make a profit is not long for this world. Given that you own the business' equity, your equity is worth something only to the extent that money is left over after all other obligations are met. For a going concern, this is achieved only if you invest the assets of the business at a rate that at least exceeds the cost of your debt financing. Only in this case will any value accrue to you, the owner.

To obtain a fair return on your investment--one commensurate with the risk of your equity stake--your business must earn a return that equals your weighted average cost of capital. See the definitions of "Weighted Average Cost of Capital" and "Hurdle Rate" in the accompanying "terms to know" article.
COPYRIGHT 2006 D.L. Perkins, LLC
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2006 Gale, Cengage Learning. All rights reserved.

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Publication:The Business Owner
Geographic Code:1USA
Date:Sep 1, 2006
Words:1258
Previous Article:From the editor.
Next Article:Terms to know: debt and equity capital.
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