Imagine that you are planning a road trip. You know where you are, you know where you want to be, so you consult a map, or plug the coordinates into your GPS. That’s it. Now to your means of transport, your car. You check that it is road-worthy and that your chances of breakdown are low. You check the oil, make sure you have enough fuel to see you at least to the next petrol station and off you go.
Simplistically, the implementation of any strategy or plan would require a similar thought process.
In the corporate world, a company will often have a plan, a strategy and have many of the tools to achieve their goal, but how do they make sure that they get to their destination?
Using the same analogy then, your product, management team and sales teams might be the fuel that drive your progress, but it is often the availability of finance which is the oil that lubricates the moving parts. Without lubrication an engine might start, but it won’t be long before various elements start to grind against each other, to overheat, become misshapen and eventually the whole vehicle will come to a shuddering halt.
To continue the analogy, there are many types and grades of oil – chose the wrong one and you are headed for trouble. A can of “WD-40” won’t be much use as a lubricant in the engine of your family car. Similarly, a corporate probably is not best advised to implement a programme of expansion or asset purchases through sole reliance on its overdraft facility from its High Street lender.
Term of Loan
It is astonishing how many companies get into trouble, especially during a period of growth, through a mis-match between the structure of their debt and their assets – for example, with longer term assets (such as land and buildings) being funded by short-term debt. (i.e. overdraft).
It would seem obvious to have a long term corporate mortgage on your factory or premises while your stocks and debtors are financed via short-term debt or committed working capital finance. However many companies get into difficulties because the tenors of their liabilities are too short and they end up struggling needlessly.
Also, the timing of interest payments and loan repayments need to match cashflow.
Lenders will charge different rates for different maturities of loan as well, as many of us know from when we try to borrow money to buy our homes. The lowest interest rate mortgage isn’t always the one that is best suited for your purpose.
The same applies in a corporate setting where there would be a significant risk in borrowing money cheaply on a three-year fixed interest rate if you know that it is going to take you 10 years to pay the debt off. You will need to refinance at least part of the original amount after 3 years. You therefore run the risk that interest rates are higher at the time of re-financing – or that finance isn’t available at all.
Security
Along with getting the structure and price of your finance correct, it is also important to give the lender no more security than is appropriate. Lenders are seldom stupid or naïve, so will generally start negotiations with a “demand” for the best possible security available, not just a security interest in the assets under consideration.
To use the example again of raising a mortgage to buy a house. The mortgage lender demands a first charge over your home, but you wouldn’t also give him security over all of its contents, your car, your pension and your savings. Aside from the fact that it would prevent you from raising further cash against those assets it might prevent you from liquidating or selling your possessions if and when you might wish.
And if, heaven forbid, you default and lose the house, you will not have lost everything. Market forces and government regulations dictate (thank goodness!) that the mortgage lenders tend to focus just on the property that they finance.
The corporate borrower does not benefit from similar protection. Here the lender will often ask for as much security as they can get such as a Debenture (i.e. a first fixed and floating charge over ALL corporate assets), personal guarantees and a second charges over Directors’ family homes to support those guarantees. They will want to reduce their risk to an absolute minimum.
Cash flow
I mentioned cashflow earlier and is essentially these flows of cash that we are talking about when we discuss finance – whether they are flows to and from suppliers and buyers or interest payments or money that is spent in certain projects or acquisitions. Cashflow is very different from profit, but it is a fact that some companies, often SME’s, can confuse the two.
Profits are what the majority of businesses want to achieve, but businesses die without positive cash flow. Finance of cashflow is the oil, the lubricant that facilitates the environment where profitability can be achieved, sustained and often improved.
Many profitable organizations, particularly start-ups, have failed because of a lack of cash. Not necessarily through a lack of funds to finance expansion through acquisition, of term assets or projects, but through a lack of ready cash needed day-to-day to pay suppliers and overheads.
There was a critical change in English company law in 1986 through the Insolvency Act which has since seen many seemingly “profitable” companies fail. Prior to 1986, solvency was generally measured by a company’s assets exceeded its liabilities. Since 1986 this is no longer the case. A court can now deem a company insolvent purely as a result of a company not being able to pay its debts in the near term.
Diversification of Funding Sources
During my 40-year banking career I have witnessed many corporate successes but also many failures and it is astonishing how similar the causes of failure often are. Right at the top of the list is mis-managed short-term debt. The most renowned in my sector is one case of a well-known trading company which had all of its short-term debt in one syndicated arrangement, led by 4 huge banks and syndicated to around 30 others.
One year, when it came time to renew the facility, the big banks didn’t want to renew. There was no obvious or overwhelming reason for this. The banks just decided that they no longer liked the sector, or perhaps the pricing, even though the company was trading profitably enough at the time.
Whatever the reason, the effect on the company was disastrous. A new facility could not be put in place in time and the company was technically insolvent on the day that the renewal failed. No ifs or buts – that was it. Administration soon followed and everybody lost – shareholders, banks and other creditors.
This is an extreme but true example with a very clear message: putting all of one’s financing eggs in a single basket is extremely risky.
This then begs the question of why the company in question did do that. Was it for the sake of convenience? Cost? Could the company have been better advised in the first instance and the whole scenario avoided?
Finance and Corporate Strategy
Having the right finance available to lubricate your corporate engine is an absolutely vital part of implementing your corporate strategy. Some might argue that a company with sufficient equity should not require even working capital finance, but this doesn’t hold water (except for services companies with few assets).
Shareholders expect their return to be leveraged by debt finance. This means using debt to finance anything that banks will lend against – assets, receivables, a large corporate balance sheet, etc. – with the equity only used to finance the balance. Banks will, in any case, demand that sharehonders provide an “equity contribution” – some “skin in the game” from the shareholders.
One final point, please do read the small print of any loan document and, if the lender suggests that you take professional advice before signing up, think very carefully before ignoring such advice. To repeat, lenders are seldom stupid or naïve and invariably seek to put themselves in the best possible position.
This might include their ability to prevent you granting security to other lenders, to put your business into administration if you are in default (however that may arise) with very little notice or simply to take possession of your assets and sell them without reference to you.
For these and many other reasons, banks and financiers are seldom flavour of the month these days, but they remain a very necessary means to an end. Most successful businesses need to raise finance for their working capital, fixed assets or projects at some point and there are many lenders who provide this. Selecting the right lender, with the right structure – the appropriate term of finance and with the correct security granted over the right assets at the right price – that is the trick. Get it wrong and things can deteriorate very quickly, no matter how successful an over-arching corporate strategy might be.
Aletheian Advisors helps organisations to achieve better results by improving the way that they put their strategy into practice. One key element of that is the manner in which your business is financed. We help to ensure that the right type of finance is in place for the day-to-day needs of your company in order that your corporate strategy can be implemented as seamlessly as possible.
For more information please visit our website www.aletheian.co.uk
