FINANCIAL MANAGEMENT

(FIMA 30013)
MODULE 6: PLANNING THE FINANCIAL STRUCTURE

What Is Financial Structure?

Financial structure refers to the mix of debt and equity that a company uses to finance its
operations. This composition directly affects the risk and value of the associated business.
The financial managers of the business have the responsibility of deciding the best mixture
of debt and equity for optimizing the financial structure.

In general, the financial structure of a company can also be referred to as the capital
structure. In some cases, evaluating the financial structure may also include the decision
between managing a private or public business and the capital opportunities that come with
each.

Understanding Financial Structure

Companies have several choices when it comes to setting up the business structure of their
business. Companies can be either private or public. In each case, the framework for
managing the capital structure is primarily the same but the financing options differ greatly.

Debt capital is received from credit investors and paid back over time with some form of
interest. Equity capital is raised from shareholders giving them ownership in the business for
their investment and a return on their equity that can come in the form of market value gains
or distributions. Each business has a different mix of debt and equity depending on its needs,
expenses, and investor demand.

Private versus Public

Private and public companies have the same framework for developing their structure but
several differences that distinguish the two. Both types of companies can issue equity.
Private equity is created and offered using the same concepts as public equity but private
equity is only available to select investors rather than the public market on a stock exchange.
As such the equity fundraising process is much different than a formal initial public offering
(IPO). Private companies can also go through multiple rounds of equity financing over time
which affects their market valuation. Companies that mature and choose to issue shares in
the public market do so through the support of an investment bank that helps them to pre-
market the offering and value the initial shares. All shareholders are converted to public
shareholders after an IPO and the market capitalization of the company is then valued based
on shares outstanding times market price.

Debt capital follows similar processes in the credit market with private debt primarily only
offered to select investors. In general, public companies are more closely followed by rating
agencies with public ratings helping to classify debt investments for investors and the market
at large. The debt obligations of a company take priority over equity for both private and
public companies. Even though this helps debt to come with lower risks, private market
companies can still usually expect to pay higher levels of interest because their businesses
and cash flows are less established which increases risk.

Debt versus Equity

In building the financial structure of a company, financial managers can choose between
either debt or equity. Investor demand for both classes of capital can heavily influence a
company’s financial structure. Ultimately, financial management seeks to finance the
company at the lowest rate possible, reducing its capital obligations and allowing for greater
capital investment in the business.

Overall, financial managers consider and evaluate the capital structure by seeking to
optimize the weighted average cost of capital (WACC). WACC is a calculation that derives
the average percentage of payout required by the company to its investors for all of its capital.
A simplified determination of WACC is calculated by using a weighted average methodology
that combines the payout rates of all of the company’s debt and equity capital.

Metrics for Analyzing Financial Structure

The key metrics for analyzing the financial structure are primarily the same for both private
and public companies. Public companies are required to file public filings with the Securities
and Exchange Commission which provides transparency for investors in analyzing financial
structure. Private companies typically only provide financial statement reporting to their
investors which makes their financial reporting more difficult to analyze.

Data for calculating capital structure metrics usually come from the balance sheet. A primary
metric used in evaluating financial structure is a debt to total capital. This provides quick
insight on how much of the company’s capital is debt and how much is equity. Debt may
include all of the liabilities on a company’s balance sheet or just long-term debt. Equity is
found in the shareholders’ equity portion of the balance sheet. Overall, the higher the debt to
capital ratio the more a company is relying on debt. Debt to equity is also used to identify
capital structuring. The more debt a company has the higher this ratio will be and vice versa.

Debt-to-Equity (D/E) Ratio

Debt-to-equity (D/E) ratio is used to evaluate a company’s financial leverage and is

calculated by dividing a company’s total liabilities by its shareholder equity. D/E ratio is an
important metric in corporate finance. It is a measure of the degree to which a company is
financing its operations with debt rather than its own resources. Debt-to-equity ratio is a
particular type of gearing ratio.

• Debt-to-equity (D/E) ratio compares a company’s total liabilities with its shareholder
equity and can be used to assess the extent of its reliance on debt
• D/E ratios vary by industry and are best used to compare direct competitors or to
measure change in the company’s reliance on debt over time.
• Among similar companies, a higher D/E ratio suggests more risk, while a particularly
low one may indicate that a business is not taking advantage of debt financing to
expand.
• Investors will often modify the D/E ratio to consider only long-term debt because it
carries more risk than short-term obligations.

What Does D/E Ratio Tell You?

D/E ratio measures how much debt a company has taken on relative to the value of its assets
net of liabilities. Debt must be repaid or refinanced, imposes interest expense that typically
can’t be deferred, and could impair or destroy the value of equity in the event of a default. As
a result, a high D/E ratio is often associated with high investment risk; it means that a
company relies primarily on debt financing.

Debt-financed growth may serve to increase earnings, and if the incremental profit increase
exceeds the related rise in debt service costs, then shareholders should expect to benefit.
However, if the additional cost of debt financing outweighs the additional income that it
generates, then the share price may drop. The cost of debt and a company’s ability to service
it can vary with market conditions. As a result, borrowing that seemed prudent at first can
prove unprofitable later under different circumstances.

Changes in long-term debt and assets tend to affect D/E ratio the most because the numbers
involved tend to be larger than for short-term debt and short-term assets. If investors want to
evaluate a company’s short-term leverage and its ability to meet debt obligations that must
be paid over a year or less, they can use other ratios.
Debt Financing vs. Equity Financing

When financing a company, "cost" is the measurable cost of obtaining capital. With debt, this
is the interest expense a company pays on its debt. With equity, the cost of capital refers to
the claim on earnings provided to shareholders for their ownership stake in the business.

Debt Financing
When a firm raises money for capital by selling debt instruments to investors, it is known as
debt financing. In return for lending the money, the individuals or institutions become
creditors and receive a promise that the principal and interest on the debt will be repaid on a
regular schedule.

Equity Financing
Equity financing is the process of raising capital through the sale of shares in a company.
With equity financing comes an ownership interest for shareholders. Equity financing may
range from a few thousand dollars raised by an entrepreneur from a private investor to an
initial public offering (IPO) on a stock exchange running into the billions.

KEY TAKEAWAYS

• When financing a company, "cost" is the measurable cost of obtaining capital.

• With equity, the cost of capital refers to the claim on earnings provided to shareholders
for their ownership stake in the business.
• Provided a company is expected to perform well, debt financing can usually be obtained
at a lower effective cost.

Alternative Forms of Financing

It happens all the time. Companies need capital, but they aren’t bankable. Banks or other
financial institutions will not touch them because they are either too risky, not able to meet
covenants, or it just doesn’t work out for some reason. So, where do those companies go?
They need to look at alternative forms of financing. In this week’s blog, we take a look at
alternative financing and why there is a need for it.

What is Alternative Finance?

What is alternative finance? The US Small Business Administration defines it as “financing
from external sources other than banks or stock and bond markets”. It typically refers to
fundraising through online platforms; however, there are various sources that could be
considered alternative forms of financing.
The Need for Alternative Financing

Why is there a need for alternative financing? Not all entities (banks, stock, bond markets,
etc.) are willing to finance certain companies due to a variety of reasons. For example,
Company A is a 2-year-old company that has a technology that will not be ready for market
for another 6 years. A bank most likely will not fund that project because there is no revenue
for 8 years and there is no guarantee that the company is ever going to be successful.
Alternative forms of financing will help Company A continue to research and develop its
product and bring it to market. In addition, alternative financing often provides benefits like
mentorship, customer validation, advice, and buy-in.

Alternative form of Financing

Crowdfunding

Crowdfunding is the most public form of alternative financing. It’s simply an online platform
where many investors invest small amounts in a company. Popular crowdfunding sites
include Kickstarter, Indiegogo, and GoFundMe. This is a great option for companies that
have customers who want what they have but the bank does not agree. For example, some
indie films have raised capital via crowdfunding platforms as both a marketing effort and
capital raising. As a result of investors’ donations, they get perks such as rewards, early
access, etc.

Grants

Other alternative forms of financing include grants, competitions, and accelerators. Grants
do not have to be paid back, unlike a loan. They are usually disbursed or gifted by one entity.
Often, that entity is a government department. It could also be a corporation, trust, or
foundation. Most grants require an extensive application process. In addition, most grants
are designated for a specific purpose – like research and development. Grants, competitions,
and accelerators often require business plans, financials, projections, etc. A benefit of going
this route is to continually improve the business and add value. If you want to learn 5 other
ways a CFO can add real value, then click here to download our 5 Ways a CFO Adds Value
whitepaper.

Private Equity
Private Equity firms are funds, and a team of individuals manages this fund that provides
debt and equity to businesses. Usually, the “hold” period for the investment can be anywhere
from 3-7 years. The Private Equity (“P.E”) firms bring best practices and find synergies with
other portfolio companies to streamline costs. P.E. firms sometimes specialize in an industry
or market to align their interests. Depending on the type of firm, private equity investors may
take a managing role in a company.