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Committing to capital or debt

WITH interest rates on the rise many business people are considering their funding needs for the 2003 financial year. They may be considering the purchase of a property, plant and equipment, or lifting the existing sales staff, which has its own inherent costs. The question to be asked is: ‘Do I use capital or debt to meet these acquisitions and increased expenses?’

Clearly the first step is to understand the differences between the two forms of funding for a project or company expansion.

In most cases, debt is provided by an outside party to the company and creates a liability to the company. The debt will usually have very specific repayment terms, which will have a maximum term before the loan is repaid and on what basis the repayments will be based (monthly, weekly etc). The loan may well be secured against the assets of the company and/or the assets of shareholders. The benefit to the financier of lending money to the company is the interest rate and/or fees that the financier will charge.

Capital is money provided by the shareholders of a company and is not subject to formal security being taken. It is listed in the equity section of the balance sheet on the same side as the liabilities. It is, however, the repayment term and the cost of equity that sets it apart from debt. There is usually no repayment term in place for repayment of capital and it is only when shares are sold or equity removed through some other vehicle that the principle amount is returned to the shareholder.

In relation to the cost of capital it is here that the main benefit exists. Shareholders are paid dividends on their shares, commensurate to their level of shareholding and the level of profits generated by the company. If there are no profits then there are no payments made to shareholders.

There is, however, an enforceable requirement to meet the interest commitment on debt regardless of whether profits were generated or not.

In these times of rising interest rates and tightening bank credit policies, business is faced with rising debt commitments in an environment where profitability is also under severe pressure. It should be considered whether it is financially viable to take out that loan or overdraft, or whether to inject capital.

Many of you would be screaming: “What capital” and I would quite understand, as SMEs are some of the most undercapitalised businesses in Australia.

And it is a lack of capital that accounts for a large proportion of bankruptcies every year. But if debt is so expensive, where do I get capital if I have no reserves?

Venture capital is the current catchcry, and many are wondering whether this will be their saviour or their nemesis.

In the US the level of venture capital involvement is enormous and is available to all levels of business. It is the backbone of most small start-up businesses and the only reason many even make it through their first five years. In Australia, although a growing sector of the economy, it is still in the infancy and somewhat nervous stage of its development.

It is looking for companies with the ability to grow to an initial public offering (IPO) that will give them an exit strategy. But why aren’t they there for the long term?

To attract venture capital a company needs to have an idea or product that is unique or a method of distribution that will achieve economies of scale and generate large levels of capital growth and profitability. They are looking to take a percentage of your business, inject funds and seek no repayments until the idea is brought to a share market float, at which time they will reap their capital gains.

So are they the evil witch or a knight in shining armour? Many companies’ dreams would never become reality without the venture capitalist. The companies may have to give up 40-60 per cent, maybe even 70 per cent of their company, but is 100 per cent of nothing better than 40 per cent of something substantial?

To many, however, their dream can be railroaded in a direction they never wanted, as their level of control and artistic or scientific input is diluted. It is, however, a low cost, non-repayable form of funding that will allow their company to grow.

A debt load from a traditional financier would weigh down the cashflow of the company to a level where it would be almost impossible to meet any of the strategic goals.

In Australia, due to the current tax levels, many owners direct the profits of their company into other company structures.

Trust networks leave the company as almost a shell with little truly retained profits, or “owner’s equity”.

As we experience higher interest rates and uncertain markets it is the companies with high levels of capital/retained profits that will weather the storm. They will be least affected by rising interest rates and lower profit levels.

Never underestimate the power of retained capital in your business. It is your life boat, your emergency provisions. It has no interest or fees charged on it and it does not have to be repaid.

Think of it as the money the business put away for a rainy day and never underestimate the banks’ ability to offer you an umbrella when it is fine, only to take it away when it rains. Be prepared and you will be successful.



p Paul Rowe is managing director of financial consultancy firm NetFin.

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