Like the legal structure of your business, financial structure too needs attention to bring out the best out of your business in the eyes of the investors and make good ROI.
What is Financial Structure?
The financial structure of the business is the combination of debt and equity both long and short term that are used to finance assets and operations.
Not to be confused with capital structure which is a pie of the financial structure cake. The mix of debt and equity is not just about making available funds. It has a larger impact on the business right from the risk factor to valuation of the company itself.
The Chief Finance Officer or the highest in the finance sector usually takes care of the financial structure of the business.
Components of a financial structure
Companies require capital to run and the capital is drawn from the revenue of the company. But how does a company finance itself when the profits made is not enough to pay for upcoming operating expenses?
CFO or the founder (in case of startup) start roping in investments in the form of debt or equity.
Debt investment is borrowing money for an interest with a predetermined period and frequency of repayment. It is very similar to a loan except the source might or might not be a bank. Company doesn’t provide any ownership in return for debt investment.
There are two types of debts – short term and long term, which are pretty self explanatory. Short term debts are an active component of financial structuring but not a part of capital structure.
Equity is offering to own a part of the business in exchange for an investment that need not be returned. They become the shareholders/members of the company diluting the existing stake of the founder(s).
The shareholders get a profit share proportionate to their stake in the company. This is beneficial in the long run and yields better returns for the investors.
Preference share or Preferred stock is the hybrid of the two – debts and equity. It is part ownership of the business but with preference in dividend payments. Preference shares are provided upon a predetermined dividend.
The profit of the business is first paid to the preference shareholders first and only if there exists something more, the profits are shared among other shareholders. Preference shares do not come with righting power in most cases.
Account payable consists of the salary of employees to be paid and other operating expenses which appear on the right side of the balance sheet – everything that comes under ‘current liability’ and ‘working capital’ .
It is not taken into account in most financial structure topics like in valuation but it has an impact on the financial position of the company, in the broader perspective.
Optimal financial structure
The ultimate objective is to bring down the cost of capital and increase the company valuation. If the pointers are ticking in that direction, the financial structure is optimal.
A company, particularly a developing one, gets offers from various investors and fund managers and debt offers. But picking everything up as-we-go is not a healthy practice. A company needs to have a good mix of debt and equity also known as debt to equity ratio.
Developing an optimal financial structure starts right from the first step – business formation; or even before that – deciding the right legal structure for a business. The business structure determines the taxation structure.
So when planned ahead in terms of operations, expansion and overhead costs you will know how much capital is required when and based on that debts and equity offers can be executed.
Key Factors of Financial Structure
The external factors are the market conditions and competitors. The internal factors are the most crucial.
Internal factors contributing to the financial structure of the business.
Cost of capital – Lower the better
Debts, equity and preference share – all come with a cost of capital with debt being the lowest in most cases and equity the highest.
Control – higher the better
Inviting more and more equity investments leads to dilution of the founder’s stake leading to lesser control over the company. The control can be held back by offering non-voting shares in case of corporations.
Credibility of the company – higher the better
Good credibility opens doors to debt opportunities. Lower credibility leads to major dependence on equity investors and dilution of shares. Credibility is built through market presence, good history of management and debt history.
The business must be able to accommodate changes in terms of capital sourcing and adapt to the requirements. For instance, the founder having 51% share makes accepting equity investment too risky as the control will be lost.
Leverage is the usage of debts for investment and lesser weightage on equity. That however is good only to an extent as higher debts will increase the risk of solvency.
How to arrive at an optimal financial structure?
Using the perfect mix of short-term debt, long-term debt, equity and preference shares to finance business operations and attain the lowest cost to capital and grow company valuation is the way to optimal financial structure.
So, what is the right mix of debt and equity?
Investors’ readiness to invest in equity for a company reflects the trust in the company to grow and prosper – which also means low risk of failure. But routing every financial requirement as equity investment will reduce the founder’s share in the company leading to loss of control.
On the other hand debts are very light on Cost of Capital. But accumulating more debts brings solvency issues. Debt is offered based on existing portfolio, projected growth and assets owned by the business. So that reflects the creditworthiness. It is difficult for a startup or infant business to secure a huge debt investment.
Equity investments is the most common in the growth phase as it offers yields close to 10x the investment compared to 8-10% in interests for debt investment.
So, to the question of what mix of debt and equity is right, there is no straight answer. The requirement of debt & equity compared to availability of debt & equity keep changing based on factors both internal and external.
Businesses require continuous reassessment and restructuring of finances to keep it relevant and effective. So how do you measure if the financial structure is optimal or not? It can be done by checking if revenue and company valuation has met the expectations.
Weight of Average Cost of Capital (WACC) is a key metric that is used to find the valuation of business. It’s a key marker used to identify if the business is optimized financially.
WACC involves cost of equity (Ke), cost of debt (Kd), weightage of equity in the whole financial structure (We) and weightage of debt (Wd). To find the valuation of the company or WACC use the formula -> Ke*We + Kd(1-tax rate)*Wd
Apart from WACC, other metrics like debt to equity ratio, asset to equity ratio will help paint a picture of the financial state of the company.
The extent of leveraging opportunities in the financial sector of a business does not end here. Options like tax optimization go beyond conventional methods but are right within the limits of law to form a company in any tax free zone or choose a business structure that allows paying the least amount of taxes, etc.
Financial structuring and tax optimization alone can improve profitability by 20%.