An understanding of funding and funding mix is critical for any business.
When looking to grow a business, often owners do not understand what funding mix is optimal for their business. This includes the relationship between debt, equity or cash funding of a business operation and why they are all different.
Debt vs Equity
This is where it is critical for business owners to understand the difference between Debt and Equity.
Debt is money raised by borrowing. Borrowings can be secured against assets or be unsecured. Debt generally needs to be paid back to the lender in a defined time-frame with tax-deductible interest paid charged against profit.
Equity in finance is the Net Worth of the company in the form of owner's funds in exchange for shares and surplus in the business. The investment of funds is generally done for the long-term with expectation of a dividend paid from profit. Equity funding involves selling shares to raise funds.
Ideally Equity should be at a level that is twice that of Debt, or 2:1.
Business Growth Case Study
Let's take an example for a Professional Services 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:
| 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). (For more on EBITDA refer to our blog - 'What-is-my-business-worth?)
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.
Next Steps...
The next decision for management was to double down for further acquisitions, retire debt, or do nothing? To help make the best decision the business needed to understanding its Funding Mix.
Understanding Funding Numbers
As part of the process, management worked through these four financial ratios to help with their understanding of funding:
a. 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.
b. 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.
c. 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! How close it goes to 1 times depends on the quality and certainty of the income of the business.
d. 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 quicker the business may want to retire debt. This is mitigated by assessing the price of debt against where there could be better returns from deploying cash elsewhere.
To Summarise:
| 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.
|
Funding Insights and Actions
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.
With this knowledge, management made the following decisions:
- The Business committed to detailed a cash flow forecasting
- Credit control processes were addressed to respond to an increase in as debtor days
Confidence to Fund Growth
After this review the business gained confidence around the sustainability of its future cash flows and profits.
The owners decided to undertake a further acquisition for $500,000. The business used $100,000 of cash (after improving accounts receivables collections) and borrowed another $400,000.
The Balance Sheet after this second acquisition was:
| 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 of well over 3 the decision was made to:
- Suspend the payment of dividends to preserve cash
- Use this cash to retire debt more aggressively
The acquisition generated a good EBIT so the other key funding ratios remained well in check.
As a result, and despite aggressive short-term growth, the business was able to create a funding structure to sustain operations for the long-term.
More Information?
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