Our first article as part of our three-part capital structure series, discusses the importance of reviewing your existing capital structure; why it is particularly important following the events of the COVID-19 pandemic, during times of expected growth and how it can help you to appropriately appraise value creating opportunities.
When we’re talking about your capital structure, or working capital structure, we’re ultimately talking about cash. Cash is what enables a business to operate – it’s the old age adage that revenue is flattery, profit is sanity, but cash is ultimately King. Therefore, when we talk about capital structures we ultimately mean whether the business has sufficient liquidity and cash to operate and make the most of the opportunities around them.
When growth and performance are going well, that’s when it is easiest for businesses to get into bad habits and get away with it because there is sufficient cash operating in the business to disguise any inefficiencies in cash management and overall capital structure. However, often when we talk to clients, for whatever reason, they haven’t been able to obtain an optimal capital position both in terms of external funding, but also in regard to their own balance sheet. Therefore, if and when things get more difficult and you haven’t got the right structure in place, then those difficulties will only get worse. Given the events of the COVID-19 pandemic, now is a fantastic opportunity to get everything in order and put yourself in the best position possible.
As a result of the impact of the pandemic, we saw a lot of businesses looking at their structures and their funding positions to try and find a way to free up cash. When we went into this 18 months ago, many businesses hit a brick wall in terms of understanding what the future looked like and having to assess their positions and re-evaluate whether they’re making the most out of working capital. Certainly we saw a lot of businesses as a result improving their debtor collection, reducing stock levels, getting greater operational efficiency, and consequently freeing up significant cash. Many businesses have found that cash balances are better now compared to early 2020. However, as we return to normality these cash surpluses will start to erode. Government support packages on loans, VAT, and rent deferrals have come to an end and debts that have built up need to be repaid.
Tight cash management practices will start to slip back to normal practices, post Brexit supply chain issues are increasing working capital requirements and inflation will lead to reduced profitability and more cash being tied up in stock and debtors, and the accelerated grow many businesses are seeing will require investment. Therefore, how businesses manage their working capital and appraise their funding requirements coming out of a pandemic will be really important for their future survival and success. Those businesses that have survived, or even thrived, during the last 18 months have done a fantastic job to get here, but now the hard work carries on – it’s time to step back, take stock and ensure you’re prepared to continue weathering the storm.
Where to start?
Firstly, what do we mean when we talk about capital structure? When we talk about capital structure, we mean the blend of debt and equity within a business that is used to fund operations and growth. Assessing a business’ capital structure, alongside reviewing working capital, are both measures of the strength of a business’ balance sheet.
One of the first things to think about when reviewing your existing capital structure is to consider how you compare against some of your histories. For instance, if you look back at some of the previous years of trading thing about:
- How does capital and working capital look and have there been any particular periods that have been better than others?
- What were the reasons behind why you could manage it better then?, and finally
- What are the reasons why it’s not so good at the moment?
The next thing to look at is your peers and what you are seeing from them in the market place. If you can, see what you can glean from how they’re managing working capital and their capital structure from statutory information, or ask your advisors to help you access that information if possible.
By combining these two comparisons, if you’re in the top quartile then great, you’re likely in a prime position to plan, appropriately implement your strategy for the next couple of years, and focus on the opportunities important to both management and shareholders. If not, then it’s probably worth doing a deeper dive to think about the things you could be doing to improve your position. It can be helpful to do this on a line by line basis in order to identify where there are blockages causing things to not free up and generate cash. Examples we’ve seen of this in the past include small errors on deliveries result in invoices being rejected in full, the requirement to create a new purchase order, a new invoice, a credit note against the pallet etc., all adding significant time on to the working capital cycle. By focussing on minimising or eradicating the occurrence of things like this, you can be amazed at how much cash frees up for other things.
This article was written by Phil Sharpe, a partner in the SCF team. If you believe you’d benefit from reviewing your capital structure but are unsure of where to start, or have done a review and want to know how to move forward, then please contact Price Bailey’s Strategic Corporate Finance team using the form below.
We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide, and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.