MCP Financial Resources and News

Business Finance Literacy - Funding

Written by David McCleery | May 2, 2021 12:42:21 PM

"Funding is critical for any Business..."

It is critical to understand the composition of your funding. This includes the relationship between debt, equity or cash funding of a business operation and why they are all different.

Many owners may not understand what funding mix is optimal for their business too.

This blog aims to highlight and draw a greater understanding of the composition of debt v equity v cash funding of the business operation, and context for movements.

This is where it is critical for business owners to understand the difference between Debt and Equity.

Let's take an example for a small service firm we worked with that had bought a new business, and was looking to expand further.  This business was funded wholly by debt, using the existing and new assets as security.

The Balance Sheet after this acquisition was as follows:

Assets $'000  Liabilities $'000 
Cash, Debtors, WIP $940,000 Creditors & Accruals $248,000
Fixed Assets $72,000 Debt - Current $200,000
Acquired Goodwill $1,000,000 Debt - Non-Current $1,100,000
TOTAL ASSETS $2,012,000 TOTAL LIABILITIES $1,548,000

At the end of the financial year, the review of the financials was encouraging, with increasing revenue from the acquisition leading to improved Earnings before Interest, Taxes, Depreciation and Amortisation ("EBITDA").    

From our learnings in Part 1 Profit v Cash flow, EBITDA was $534,750 versus a Cash EBITDA of $432,750 (a increase in Receivables Days the main cause for the difference).

Otherwise, the transition of the new business had gone relatively smoothly. A dividend of $200,000 was declared, though this was lower than previous years despite revenue growth.

The next question for management, double down for further acquisitions, retire debt, or do nothing?  To help with these critical decisions the business needed to understanding its Funding Mix.

The Funding Numbers

As part of the process, management worked through some key financial ratios to help with their understanding of funding:

Debt to Equity Ratio
A measure of the extent of how the business is financing its operations through debt versus wholly-owned funds. Calculated as:

Total Debt ($1,300,000) / Total Equity ($464,000) = 2.80 

A ratio >1.0 shows that a considerable portion of debt is funded by assets, a ratio below 1.0 means a greater portion of assets are funded by equity.

Interest Cover
A measure of how easily a business can pay interest on its outstanding debt. Calculated as:

Total EBIT ($524,500) / Total Interest ($62,500) = 8.39

When a company's interest coverage ratio is say 2.0 or lower, its sustained ability to meet interest commitments may be questionable.

Debt Service Ratio
A measure of how easily a business can pay total debt repayments on its outstanding debt. Calculated as:

Total EBIT ($524,500) / Total Debt Commitments ($162,500) = 3.22

Where this ratio is 1.0 or lower, cash flow will be negative!  So how close it goes to 1 times depends on the quality and certainty of the income of the business.

Payback (Debt) Ratio
A measure of how quickly total debt can be repaid out of EBIT and cash reserves.

Total Debt ($1,300,000) - Cash ($12,000)  /Total EBIT ($524,500) = 2.41

The greater the uncertainty around future earnings, the more quickly the business may want to retire debt. This is mitigated too but the price of debt, where there may be great returns from deploying cash elsewhere.

Measure

Result

Comments

Debt to Equity
2.80 times
High level of gearing - will need reliable future earnings to support.
Interest Cover
8.39 times
Strong earnings that support interest commitments.
Debt Service Ratio
3.22 times
Can change quickly based on amortisation requirements from the financier.
Payback Ratio
2.41 times
Very relevant measure especially given the high level of gearing.

Insights 

The acquisition in this case drove a very high debt to equity ratio for the business. Management then placed a focus on the quality of future revenue and management of their working capital to ensure that cash followed profits.

The learning in this example for management:

- The Business committed to detailed a cash flow forecast; and
- It addressed credit control processes as it debtor days had increased.

Funding Growth

After this review, the business build some comfort around the sustainability if its future cash flows and profits.

It decided to undertake a further acquisition for $500,000. The business used $100,000 of cash (after improving collections) and borrowed another $400,000. The Balance Sheet after this second acquisition was as follows:

Assets $'000  Liabilities $'000 
Cash, Debtors, WIP $840,000 Creditors & Accruals $248,000
Fixed Assets $72,000 Debt - Current $200,000
Acquired Goodwill $1,500,000 Debt - Non-Current $1,500,000
TOTAL ASSETS $2,412,000 TOTAL LIABILITIES $1,948,000

With a Debt to Equity Ratio now well over 3, the decision was made to:

- Suspend the payment of dividends to preserve cash; and
- Use this cash to retire debt more aggressively.

Though with the acquisition generating a good EBIT, other key funding ratios remained well in check.

As a result, and despite some aggressive growth, the business was able to create a funding structure to sustain itself for the long term.

More Information?

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