By: Jeff Henderson
One of the challenges facing all business owners is optimizing their capital structure. Capital structure is the ratio of different sources of capital being used in the business. The most common sources of capital for small business owners are debt, equity and hybrid securities. Working capital for small business is the difference between short term assets and short term liabilities. Short term is less than one year. Short term assets generally include cash, accounts receivable, and inventory. Short term liabilities are accounts payable, current loan payments (principal), and lines of credit.
Debt involves a contractual agreement between the company and a third party that calls for the repayment of the debt and interest for the use of the capital regardless of the company’s performance. Interest payments are generally tax deductible, and the debt has a fixed or determined term. Examples of debt financing are bank loans, commercial paper and corporate bonds. Equity financing is permanent because it involves exchanging a share of ownership in the business in exchange for the capital. Equity financing often provides for the payment of dividends which are usually not tax deductible. Hybrid securities share some characteristics of both debt and equity. The most common type of hybrid security would be a convertible bond which could be converted to equity at an agreed upon time and conversion rate.
Getting the Right Mix
Optimizing capital for any business is a mix of liabilities and equity that meets the business objective at the lowest cost. Attention must be given to make sure that the business adheres to regulatory requirements and allows for adoption of industry best practices and appropriate risk management.
Optimizing capital is a challenge for any business but the basic steps involved are the same for large or small businesses.
- Define the capital needed and the business objectives to determine if there are any elements of the business plan that would dictate a choice of the capital source or sources
- Identify any regulatory restrictions to make sure the capital structure is in compliance with all rules and regulations.
- Identify risk restrictions such as liquidity, interest rate risk or exchange rate if you plan on operating in more than one country.
- Many variables can affect the capital available to you. These could include the legal structure of your business, the markets in which you operate and regulations that apply to your business. Identify the range, amount and cost of funding instruments available based on the analysis of these variables.
- Fill capital needs with the lowest cost funding available to you as determined in the previous step.
Analysis of the financial cost of the capital structure involves estimating the weighted average cost of the capital. This is determined by adding the after-tax cost of each of the funding instruments multiplied by the percentage of the total capital each represents. Optimizing capital in small business is balancing the growth needs of the company withe least cost of capital.
Most growth-oriented companies will focus on internal sources of financing rather than external sources. Equity financing generally is an attractive source only when your business is leveraged to the owner’s or the board’s comfort level or the industry average, whichever is higher. With equity financing comes increased scrutiny from attorneys and regulators and perpetually sharing your profits.
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