Structuring Debt

Getting Your Business into Shape

A bank overdraft may not be the most appropriate way for you to structure your company’s debt, however, it still remains the preferred choice for many businesses today.

What is debt?

There are three general sources of finance for a company being:

1. Contribution by the owners or shareholders;
2. The retention of profits;
3. Other peoples money or borrowing from creditors – this is debt.

Debt has two key features in that it is received from creditors and it has to be repaid at some stage, usually under an arrangement with the creditor. Debt can be viewed as selling an asset without losing use or control of that asset or alternatively gaining the use of assets without initially having to pay for them.

What is involved in financing a business?

There is no single correct way to finance a business but the factors that need to be considered are:

• The needs of the business, such as the use of the funds for working capital, capital investment acquisition, etc; the term or repayment programme, is it short term or long term?; for whom is the money to be borrowed?, and finally the amount that is required.
• The method of finance to be used including where is the finance to be sourced, what is the most appropriate form of finance and are there any accounting and tax implications?
• The restrictions and responsibilities attaching to finance are the timing of the funds being available and when are they required; the costs of financing including interest and all hidden costs such as establishment fees, hedging costs, guarantees, legal fees, etc; the finance risk being the risk of repossession of assets on failure and the effect of the financing on the objectives of the business.

What is the impact of debt on the operations of the business?

Debt adds risk to the business. Risk is determined by the financial policies of the company and one of the main ones is the debt to equity or gearing ratio. If you increase the borrowings, you increase the leverage or risk of the business.

Businesses strive to maximise the wealth of the business, this should be based upon the maximisation and return on investment at a level of risk which is acceptable.

Debt has an impact on directors' responsibilities in that it is the function of directors to act in the best interest of the equity holders cognisant of their responsibility to outside creditors. It is important that directors fully understand their duties and responsibilities to those outside creditors.

The stage of growth of a business reflected in the table below also gives an indication of the likely debt structuring requirements of the business dependent upon its position or stage.

Stage	Financing needs	Major source of finance
1. Inception	Working capital, funds for plant, equipment and premises	Owners, friends, suppliers, leasing companies, banks
2. Survival	Working capital	Owners, suppliers, banks
3. Growth	Working capital, extended plant	Banks, new partners, retained earnings
4. Expansion	New operating units, expansion of business premises	Retained earnings, new partners, secured long term debt, additional equity
5. Maturity	Maintenance of plant, and market position (ie research and development)	Retained earnings, long term debt.

Correctly structuring the finances of a business

It is important that the structuring of finances of a business are correct and if so, they will then accrue benefits to that business. However, if the finance structuring is out of balance then there will be added costs and increased risk to that business. The table below lists the benefits of correctly structuring or the costs of incorrectly structuring the finances of the business.

Benefits	Costs
Minimise financing costs	Additional costs of finance
Minimise management time dealing with “crisis” periods	Loss of business direction
Business stability, expansion objectives	Inability to execute strategies
Increases the value of a business	Diminished shareholder support
Minimise the risk of business failure	Failure of the business
Increase the ability of the business to raise additional finance in the future	Loss of financiers confidence Inability to borrow at reasonable finance costs

What are the objectives in structuring the finances of a business?

The areas to consider in determining the objectives are:

Identify the risks associated with debt. These are:

• Liquidity risk; what is the risk of the company being unable to meet the interest and principle repayments required?
• Interest risk; what is the risk that the interest costs associated with the finance is excessive or incorrectly structured and has exposure to interest rate movement?
• Security risk, what is the risk that the security cover is inadequate due to changes in the market or environment?

In structuring the finances of the business there is a need to have the correct structure in respect to:

1. Mix of debt to equity
This is an important mix and one that if it is out of balance means excessive risk or under realisation of the potential of the business.
2. Maximisation of internal funding
This is the cheapest form of finance to a business and is internally generated by cash flow optimisation and the correct management of working capital.
3. Sources of finance
This depends on numerous features such as the type of industry, the stage of growth, the funding needs etc. There is a risk in obtaining funding from numerous sources equally as much as there is a risk in being too limited in your financiers. However, building a solid relationship with your financiers is important.
4. The types of financing instrument
Examples of these are leases, short term facilities, long term funding, mezzanine finance, perpetual debt, etc.
5. Terms of finance
The terms of the finance include the period of finance, the repayment programme, the interest rate, the costs in establishing and obtaining the finance, the covenants and restrictions placed by the lender on the business, the required level of security and the information flow that is required by the financiers. All of these areas need to be considered.
6. Planning for the future business and funding needs is an extremely important issue. You are not borrowing for today's events, you are borrowing for the future and in this regard, planning is essential.
7. Management control over the business
It is important that management reporting and control procedures are in place to ensure that the financing is optimised.

Streamed and structured debt

Every business should review their debt structure and stream it in accordance with the asset base of the business. Below we diagrammatically reflect the assets and finances or liabilities of a business to represent what this may look like.

Factors	Liabilities	Assets
Unsecured / Last Out	Equity	Fixed Assets
Floating / Fixed Charge	Term Loan / Debt
Asset / Chattel Security	Leases – Hire purchase
Unsecured / Last Out	Equity
Unsecured	Internal Debt – Payable / Accruals	Current Assets
Secured / Debenture / Floating	Secured Debt – Overdraft
Romalpa / Preferential	Internal Debt – Payables / Accruals

The diagram lists the factors of the types of finance and streams it against the asset base.

We would recommend that all businesses undertake such a streaming programme and this should be done in conjunction with a detailed plan so that the future finance requirements of the business are covered.