market report (2/6)

The Business Survival Guide – Capital base managment
AS markets continue their volatile patterns, this month’s tip focuses on capital base management (CBM) in the SME space. Unlike larger entities that have been forced to consolidate, rationalise and cut costs to stay afloat or stay ahead, SMEs operate in a very different space of the market and still have room to expand. This article looks at CBM, what it means and how to achieve it from both a debt and equity perspective.

At its simplest, CBM ensures that your business has sufficient capital for planned activities and to promptly seize opportunities as they arise. A good CBM program will adopt a longer term approach and will continually scope for opportunities, reconsider strategy and seek to adjust the flow of funds to suit these needs. Once you have a clear picture of your goals and what’s involved in achieving them, CBM drops in behind this to ensure sufficient working capital (both presently and in future) for goal realisation.

The decision to use debt or equity funding will vary for each business and will depend on factors such as current debt/equity mix, credit markets, availability of cash/revenue flow to service new debt, the impact on your balance sheet or earnings per share (EPS), acceptable financial ratios in your industry and your appetite for risk.

If your cash/revenue flows are tracking well, your debt/equity ratio is still relatively low (and ideally below 1) and you are looking to increase market share, consider expansion through debt funding. Instruments such as debentures and promissory notes, or hybrid instruments (having elements of debt and equity) such as convertible notes or stapled securities, may offer benefits that are unavailable through traditional borrowing arrangements. These include greater flexibility to set the terms of funding and a broader base to raise funds from, as you may not be so constrained by financial models and criteria used by traditional financiers, and other market participants may have a greater appetite for risk. Whenever using hybrid instruments it is however, prudent to first seek advice from a finance professional to ensure that your strategy does not negatively impact your balance sheet.

For entities that are already highly or suitably geared, you may be looking to either reduce or stabilise your debt levels. In this case, your preferred fundraising strategy should focus on equity. Equity securities generally include ordinary shares (fully or partly paid), options (which may be over any equity security) and preference shares. The type of equity security offered will depend on the certainty and timing of funds required, impact on dilution and EPS and your dividend policy. For example, both partly paid shares or other instalment securities (PPS) and options may be suitable if some funds are required now and further funds are desired later. PPS enable the issuer to call up more funds with certainty and pay less dividends in the interim, however will have an immediate dilutionary effect and decrease EPS; whereas options will not be dilutionary unless exercised, require no payment of dividends, but may never provide further capital if they are not exercised. That said, don’t forget the problems BrisConnection experienced using this strategy. Preference shares are highly flexible as their terms are able to be tailored to suit particular needs and consequently may be more attractive to savvy or silent investors who are willing to give up some rights (such as voting) for greater rights in other areas (such as priority on payments to shareholders).

CBM may also be used to improve the overall ‘look’ of your business and does not necessarily involve raising funds. For example, if you are looking to stabilise your equity position and increase shareholder value, undertaking a capital reduction will positively impact your EPS. Understanding your CBM options is crucial to future proofing your business’s ability to finance and achieve corporate goals.