Entries Tagged 'Business Plan' ↓

Capital structure is part of fundamental business strategy, and top-level driver for Financial Management. And every business owner/board should have a map for how capital will be obtained for various projects.

Capital structure decides what combination of debt and equity will be used to finance the business projects. And it thereby decides the value basic parameters like cost of capital, earnings per share and valuation.

Arriving at the capital structure will depend on multiple factors: owner/shareholder expectations, industry type, tax policy-high corporate rates favor debt, and overall corporate risk.

Assuming there are real projects to deliver real growth (an important assumption), then if company’s equity investors expect the stock to go up 10%+ per year, and if the company can borrow money at 6%, then the company should have some debt as a source of capital.

Now, the point to note here is that it will benefit the equity investors and share price to have some debt, but overuse of debt (over-leverage) is not healthy because it increases the risk in the company’s earnings stream, which in turn tends to lower the valuation and hence the share price.

So each business owner/board will have to find their zone of comfort and create a capital structure policy that makes a trade-off between risk and return, which is acceptable to all investors.

Just take a look at the following section – it’s from BBC website on Jan 20, 2002 – when the global economy was severely down, and almost every tech company was losing revenues and market value on a daily basis.

Profits plunge in 2001

Motorola slashes jobs Infineon chip slump Dell’s price war Ericsson shock Unisys profits halve Sony’s heavy losses Fujitsu slides into red Compaq losses mount Microsoft profits drop Nortel struggles Nokia sales fall IBM rare success Ad slump hits AOL Intel tumbles Bruised Apple Philips’ hefty losses Yahoo suffers Psion’s woe Palm sales halved Baltimore’s cash crunch Marconi battered Alcatel sheds staff Lucent losses widen Cisco slumps

As you will notice, all kinds of problem happened to leading tech companies in 2001-2002 – part of the reason was that they had built structures and teams very recently in 1999-2000 that were preparing for future growth – everyone was preparing – nobody wanted to be left behind – the problem being that the growth projections were just too steep. Some tech companies had planned 500-1000% increase in revenues in 2 years, and those were inflated business plans.

The situation was not very different from non-tech companies.

The question is: How does one prepare for such situations? What are the learnings from last time, which we can put into use the next time business slows down?

If you go through the above links, there are some lessons for every business owner and executive:

1. Consciously increase the Cash and Current Assets on your balance sheet from many months before you actually are in the middle of bad business season.

2. Watch your Debt/Equity, and take any possible steps to reduce the debt component, while the market is liquid.

3. If you have been thinking of selling off a business unit or a brand – because it’s not fitting with your long-term business strategy – decide Yes or No rapidly – and if it’s a Yes – then do it with top priority – otherwise it is very likely that you are losing valuation on it.

4. Outsource as much work as possible – preferably foreign countries – it helps to have business partners/vendors who are located in other markets – because they will have an incentive to help you get new business in case you are facing business slowdown in your home markets.