There are many pitfalls to be overcome if you wish to successfully expand your business. One critical factor is the method adopted for financing expansion, for example through an acquisition.
A company's basic financing structure typically consists of a combination of working capital, term debt and shareholder's equity.
The method of financing expansion is effectively an investment decision, which is driven by a company's strategic focus.
When looking for funds, consideration should be given to:
Current capital structure of the company
Management's risk policy
Availability of collateral
To what extent the company can predict future cash flows
State of the capital markets
Cost of different funding sources
Developments in interest and exchange rates
Level of control, should equity finance by considered
When looking at the capital structure, focus is placed on the ratio of debt to equity. A company that has a low level of gearing (level of debt finance) may find it easier to obtain further debt finance. The inverse is also true.
Debt financing increases a company's risk. Unlike equity, debt has predefined payment terms, and the company faces a risk of financial distress if it fails to meet these commitments. Should management have a greater appetite for risk, higher debt finance may be considered whilst companies that are more risk-averse may be more partial to equity financing.
The traditional banking approach is to provide finance based on the strength of the borrower's assets. Funding is based on the liquidation value of the borrower's assets. This approach reflects the traditional, conservative philosophy that if the transaction for which the funding is being requested fails, the bank will have the underlying assets to fall back on in order to recover all or a material portion of its money.
As a result of an overall increase in competition in the financial sector, banks are becoming increasingly receptive to supplementing their financing decisions with consideration of a company's cash flow potential in addition to the collateral provided. Considerations include the predictability of cash flow and whether the company could produce reliable and realistic cash flow projections. The cash flow projections should include supportable assumptions. These could include details of contracts concluded, marketing studies, historical information etc.
Finance providers look at different indicators in assessing a company's risk. The three broad areas are:
Management - management quality, ability, integrity and commitment
Operations/cash flow - historic, prospective and capital requirements
Balance sheet and asset values
A review of management is normally the most important assessment the lender will make in determining risk levels.
Debt funding is normally cheaper and easier to find than equity funding. Equity investors expect little or no return in the early stages, but require much more extensive reporting on the company's progress. The investor has taken the risk and expects higher returns. Therefore, investors anticipate that goals and targets will be met. When considering debt financing it is important to ensure that there is financial leverage. Financial leverage increases a company's return on equity as long as the cost of the debt is less than the return from investing these funds.
Most debt is provided at variable interest rates. The company should consider future trends in interest rates and the potential impact of movements in interest rates on the profitability of the company. Similarly, should the loan be in a foreign currency, the impact of movements in exchange rates should be considered. In the past, numerous companies have experienced significant problems because they failed to address these risks.
When equity is considered as a source of finance, the impact on control and distribution of future profits should be taken into account. Using equity financing from external sources usually leads to a dilution in control.
Regardless of the method of financing, financing considerations should start at an early stage of the transaction and not be deferred until the commencement of negotiations with the target. Having financing available early in the acquisition process allows a purchaser to act quickly and decisively when opportunities arise.
Theo van Eeden is Assurance Senior Manager at KPMG
Author: Theo van Eeden
