A business’ balance sheet highlights a very important business concept – that business is essentially made of two parts –
a) Capital is Invested, and
b) Capital is Employed.
In essence Capital makes a business, because the real cause of business failure is running out of funding! With sufficient funding businesses can survive grave situations. Even a start-up with zero revenue is able to survive if there is willing capital. The structure of a business’ capital is therefore vital in determining business stability and survival.
Here are 6 reasons why it is important for businesses to, from time to time, review their capital structure to ensure long term survival and stability. The Covid-19 environment has made the need for this task even more serious for many businesses.
1. Inappropriate Capital Structure is the cause of business failure.
At Ukwanda Growth Partners we live by the motto “Business Finance is the Number One thing in Business”. This is because of the reason mentioned above – Businesses fail for one reason and one reason only, they run out of funding. Covid-19 has demonstrated this concept in a very clear way. Many businesses that were thriving from strong monthly cashflows suddenly faced the risk of failure when that form of business funding was threatened. It is in the interest of every business to periodically review its capital structure and stress test it for business risk.
2. The economic environment is forever changing, uncovering new opportunities and posing new threats.
What works for a business today may not work tomorrow. Even under normal business conditions things change, both within the business and in its operating environment. This calls for business to revise how they fund their operations to suit their changing needs as well as the changing operating environment.
3. If you don’t take control of a distressed financial situation, your creditors and maybe even the courts eventually will.
Many businesses are facing financial distress as a result of the Covid-19 related economic shutdowns. If they are funded through some form of debt this may mean they are not able to adequately service their debt obligations. While some creditors are supportive to businesses their priority is still to protect their investments as much as possible. Creditors do need to quickly take control of situations they deem risky including insisting on a formal business rescue proceedings or even liquidation.
When this happens executive managers lose control of their business. It therefore helps to be proactive in reviewing the capital situation before creditors and the courts come in. This leaves the business with more options.
4. You can significantly improve return on your equity by carefully structuring your capital.
Proper use of external funding can earn better financial returns for shareholders than they would have with only equity capital. This is because external capital allows companies to earn more by for an example:
- pursuing business opportunities that require significant upfront investment.;
- funding operations with long cash conversion cycles;
- saving on tax expense through tax deductible finance charges; and
- leveraging equity capital by funding unlimited earnings with fixed cost funding instruments.
With carefully designed capital structures, business owners can improve their investment returns.
5. Capital structure determines the level of funding risk in your business.
The use of external funding brings numerous benefits to a business but it also brings some level of financial risk. External funding, especially debt brings with it a greater risk of bankruptcy for the business because the obligation to make fixed debt repayments does not go anywhere even when earnings drop. The Covid-19 pandemic has exacerbated this risk for many businesses.
Business earnings vary over time because of company specific factors as well as macro-economic conditions. Reviewing the capital structure from time to time helps businesses keep track of the bankruptcy risk they face.
6. There are possibly numerous ways of funding your business that you may have not considered.
Business funding is generally used to acquire business assets from which to generate earnings. It is never really about receiving money from funders, but the resources a business is able to acquire with that money. There are however numerous ways of acquiring resources beyond the traditional funding methods. Carefully reviewing capital structure can uncover some unconventional and beneficial ways of funding your business that you may not have considered.
It is to the benefit of every business to consider periodically investigating ways to optimise their capital structure.
At Ukwanda Growth Partners we provide services and expertise in capital structure reorganization and capital raising. We support businesses to create real options for restructuring and optimising capital. For more information please visit https://www.ukwanda.co.za/restructuring-capital/.
About the Author: Lindo Sibisi
Advisor, researcher and writer in Business Growth and Funding, Lindo Sibisi is the author of the South African Business Funding Directory. Passionate about economic development through business growth, he has worked with many senior business executives to support them to manage complex and important decisions in business investments and funding. He is the Founder and Managing Partner at Ukwanda Growth Partners.
The opinions expressed in this article are for general purposes only and do not constitute advice of any kind. The reader should not use the information in this article as a basis for making any business, legal or any other decision without seeking appropriate professional advice.