This leaves the critical and strategic Financial Management function largely ignored. This important element of running a business needs to be appreciated better, starting with developing the understanding that it is very distinct from mere accounting.
Financial Management involves managing the company’s financial resources to attain its objectives of achieving maximum returns for the owner. It involves mapping the financial and non-financial resources with the business goals to ensure that the running of the business is optimised.
As a planning tool, Financial Management helps to ensure how capital is raised, how it is invested, and how efficiently it is used, are optimised. As a monitoring tool, Financial Management can help a business owner identify problem areas through variance and ratio analysis.
To start with, let us consider the Balance Sheet of the business and what fundamental principles an owner needs to bear in mind. In the next article, we will look at P&L and profitability aspects.
Understanding ‘Leverage’
Firms borrow for one (or both) of two reasons
i) for want of funds because owner’s equity is insufficient
ii) increase returns available to the owner. While the first reason is clear enough, how does the second motivation work?
When a firm borrows money, it promises to pay back a pre-fixed stream of cashflows, which include both principal and interest. If the business does well and rates of return grow over time, the payments still stay fixed. This helps to magnify returns to equity owners, and hence the term ‘leverage’. Conversely, if things go wrong, the obligation to pay back the loan stands as is, which then depresses returns to owners manifold. In finance language, as long as the Return on Capital (ROC) is greater than the cost of debt, the Return on Equity (ROE) will be higher than if no debt had been used.
Apart from this upside, there are some other benefits of leverage. The interest paid on the debt is a tax deductible expense whereas the cost of equity is not. Moreover, debt provides a discipline to the operation due to its ‘double edged sword’ nature. Business managers and owners are more careful about spending and investment with the overhang that a loan provides.
While there is no one-size-fits-all rule for extent of leverage, a business should be mindful of the amount of debt that can be reasonably serviced through profits. An ACE Equity analysis of 3000 plus Indian firms shows that the average Debt:Equity ratio (ratio of amount of debt to total shareholder’s funds) has ranged between 0.69 and 0.75 in the last five years. The average varies widely between industry sectors, from a high of 3.74x for Sugar to a low of 0.21x for Oil Exploration.
MSMEs need to be particularly careful about assessing the room for leverage considering serviceability. This is due to several factors including reluctance of lenders to finance smaller businesses, volatility of earnings, harder impact of regulatory moves (like demonetisation), etc.
Borrowing profile
Apart from the absolute amount of debt and the proportion of debt used in the business, it is also important to understand what form and tenure of debt is being used. One of the most common mismatches seen, especially in balance sheets of small businesses, is that of shorter term loans financing longer term assets. Often, a business would keep borrowing on a need basis as it goes along and sometimes it may be forced to accept any facility that is available in an emergency. Apart from increasing the average cost of borrowing, using shorter tenure loans for financing fixed assets or property also puts the business at grave liquidity risk.
Another aspect is that of fragmented borrowing. Habitually, borrowers have preferred to borrow from multiple sources, and in multiple forms. Changing needs over time that require additional borrowing, refusal for further lending by an existing lender, lack of collateral – the reasons vary. This sub-optimal arrangement ends up increasing cost of borrowing and in effect also reduces ability to borrow. Under a Debt Consolidation arrangement, a lender consolidates all facilities into a single arrangement. This enhances borrower credibility, reduces administrative costs of managing multiple facilities and lenders, and lowers the effective interest outgo due to scale advantage (having a larger facility with one lender versus being a small ticket borrower with multiple lenders).
Working capital management
The third critical aspect is that of managing the blood flow of the business, i.e. the cash or working capital. Working capital is the amount of cash held in current assets and current liabilities, i.e. items that are due to be paid or received within one year. This working capital or cash cycle can be pictorially represented as:
The efficiency of this cycle is determined by how fast idle cash is converted into inventory, how fast this inventory is used up to make saleable products, how fast these are dispatched to customers, and how fast the amounts are recovered from them. In this process, how much credit period can be extracted from suppliers (and at what cost) is as vital as minimising credit periods to customers. And the efficiency of this cycle determines profits.
The above items cover the most elementary but critical aspects of balance sheet financial management. In the next part, we will look at P&L aspects and how Financial Management can help enhance profitability.
Source: The Economic Times