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c)      Financing

 

Obviously, investments must be financed. There are essentially three ways to achieve this:

 

-          you can issue debt, use the proceeds to finance your investments, pay interests on this debt and repay the principal later.

 

-          you can raise fresh equity, that is to say find new investors who want to invest in your company; in exchange, they will ask for a proportionate claim on the profits (required rate of return on equity), plus voting rights.

 

-          you can finance your investments with the internal funds of your business, that is to say with the profits which were generated in the past and transferred to your company’s reserves. Such money belongs to the shareholders, so that the return that is required is still the required rate of return on equity. Therefore, conceptually speaking, raising new equity or using internal funds are two equivalent financing methods, except that when you raise new equity you must incur transaction fees and you must ascertain that enough information about your company is disseminated into the markets so that potential investors can be found. Practically, raising new equity is therefore more costly than using internal funds. (similarly, it can be shown that raising debt is more costly than using internal funds, but less costly than raising new equity, up to a certain level of debt; this hierarchy constitutes what is called “the pecking order theory”).

 

In addition to determining where the funds are coming from, you will also need to analyze the capital structure of your business, and control its liquidity and its solvency.

 

Debt ratios

 

Capital structure: how much debt do you have on your balance sheet, as compared with equity ? In order to get an idea, you can consider the ratio Net Debt / Equity (called “financial gearing”, and where Net Debt = Long and short term debt – marketable securities – Cash available), compare it with the benchmark of your industry, and monitor the evolution of this ratio in time. Of course, you might want to measure your capital structure in different ways, for instance by looking at Total Assets / Total Liabilities, etc ... Note that there is no single method which is better than the others, and no “golden rule” to be learned; instead, you must strive to use ratios which suits best the nature and needs of your business, and which will facilitate its management.

 

After determining how much debt you are holding, you must try to quantify the financial burden it represents for the company (and therefore decide whether your company can be considered as financially distressed or not). Several ratios are used in order to achieve this:

 

-          The ratio Net Debt / EBITDA:  qualitatively, this ratio indicates how many years of EBITDA would be necessary in order to pay back all the debt (assuming both the levels of Net Debt and EBITDA are held constant). Typically, this ratio is considered as alarming when it is greater than 3 or 4, but always keep in mind that there is no golden rule and that you should look at the benchmark of your industry and take into account the specificities of your business.

 

-          The “cover ratio” EBIT/Interests on debt: represents how interests on debt weigh on your operating profit; this ratio is considered as alarming as soon as it becomes greater than 4 (but the same remark as above applies: you must consider the benchmark of the sector within which you are operating).