When planning a road trip, we typically consider the vehicle we will drive, and the fuel required to keep our engine running smoothly. After all, the journey will be a struggle without the right supplies and equipment. Likewise, certain factors are crucial to a smoothly running business, and your financial structure is one of them. So, in this post, we will define financial structure, explain why it matters, and how it will help you reach your goals.
What is Financial Structure
The term financial structure refers to the precise mix of debt and equity that fuels your organization. In other words, it is the delicate balance of long and short-term liabilities combined with shareholder’s or owner’s equity as shown on your balance sheet, next to your assets.
Going back to the road trip analogy, think of all the essential components that make up your company’s “engine.” I’m talking about the people, systems, processes, data, reporting, etc., that form the foundation of your business and keep it going – what I often refer to as your financial infrastructure. You need “fuel” (money) to build this foundation and optimize its performance. Developing a sound financial structure ensures that you have a reliable, high-quality fuel source to keep that engine running strong.
So, financial structure matters because it is an indicator of your company’s ability to run smoothly and efficiently without burning out. The right balance will ensure that you can get the type of fuel you need when you need it without incurring excess cost or risk. Therefore, if the financial structure you have in place becomes lopsided and inhibits your ability to achieve your goals, you need to fix it.
It is worth noting that there is a difference between “financial structure” and “capital structure,” even though people often use these terms interchangeably. When someone says they wish to develop an optimal capital structure, they are referring to only the long-term debt and equities that a company holds. Financial structure, on the other hand, encompasses both short-term borrowings and long-term liabilities. So, financial structure is the umbrella term, and capital structure is the subset.
What Factors Determine the Optimal Financial Structure of a Company?
When developing a sound financial structure, financial executives must consider the entirety of your business and what is suitable for you. Then, they aim to strike a balance between your assets and the various types of liabilities on your balance sheet – from traditional debt and equity sources of funds to other types of liabilities like accrued expenses, unearned revenue, and tax obligations. To this end, below are questions they might ask to guide their thinking:
What are Our Goals for the Business?
Before you start thinking about an appropriate financial structure for your company, you need to get clear on the goals? For instance:
- Are you aiming to grow your company as quickly as possible so you can sell it in 5, 10, or 15 years?
- Are you running a lifestyle company where the goal is to generate enough income for your founders and employees to live comfortably?
- Do you wish to build an enterprise and grow through acquisitions?
- Or do the goals above sound completely unattainable because you are in distress and simply want to figure out how to survive?
Once again, the road trip analogy applies here. If you wish to get to your destination as quickly as possible, you may choose to drive a Ferrari. In that case, you would need high-quality fuel (and lots of it), so your engine can perform at its best. However, if you prefer to relax and enjoy the journey, you may be happier with a roomy and fuel-efficient minivan. In financial terms, you may wish to minimize your debt even if it means it will take longer to get where you want to go, i.e., achieve your goals.
What are the Capabilities of Our Team?
Of course, it is one thing to think about your goals. It is quite another to pull together the right team.
If you are on the fast track, you will need to think carefully about the breadth and depth of your management team. Do they have what it takes to get you where you want to go quickly? Or do you need to allocate funds for hiring and training the right people for the job? Likewise, if you crave a more comfortable journey and have a high-paid team of type A individuals, you may need to adjust.
How Much Appetite Do We Have for Risk and Control?
There is a significant difference between debt and equity financing, which will impact your financial structure. In short, debt financing is when you borrow money and pay it back over time with interest. Equity financing is when an investor gives you money, but instead of paying that money back, you provide them with part ownership in your business (and the potential for a big payday when you sell the company down the road).
Both sources of funds can improve your cash flow. However, the cost, effort, and risk involved in obtaining those funds and managing the relationships will vary, depending on the sources of capital you pursue.
In general, debt financing is less expensive, but you must keep your debt obligations current, which can inhibit your cash flow. Also, if you have too much debt on your balance sheet, it can be a red flag to investors, making it harder to raise money in the future. Equity financing, on the other hand, is expensive, and you must often give up some control and ownership of the company. However, this can be an acceptable tradeoff for those who wish to grow and scale with vigor.
In Which Industry Does Our Company Operate?
The type of industry your business is in can change everything. For example, consider the following questions:
- Do you sell large quantities of inexpensive items, or do you aim to close a few big deals each quarter?
- How does this affect the types and timing of the investments you make?
- What market forces affect your cash flow? For example, do you have large and frequent swings due to seasonality, or do your revenues stay relatively stable?
- What are your projections for the coming year?
- How large or small are your margins?
- What are your facility and equipment requirements?
Your industry will influence the answers to these questions and many more, which will affect how your financial team views and manages your financial structure.
Where is Our Company at in Its Evolution?
Companies at different stages require different amounts of capital to grow. Are you an early-stage start-up in hyper-growth mode? In this case, you may need to raise equity so that you can afford to bring on the talent necessary to create and sell the products or services your firm provides.
If you run a more mature company with slow but steady growth, you may need expansion capital which can be either debt or equity depending on how much you need, how much cash flow the new funds would create, etc. It comes down to the fact that while every company has its own unique needs for capital, you must consider the stage you are at to capitalize the business appropriately.
Is this a Public or Private Company?
Every organization wants a financial structure that will empower it to pursue its goals, but the optimal mix will differ for public vs. private companies. For example, by definition, public companies sell shares to the public, are subject to the ups and downs of the market, and must adhere to certain standards. Therefore, they will be subject to constraints concerning funding.
Private companies, on the other hand, typically have more flexibility in how they structure their finances. Private companies are not beholden to the compliance and reporting requirements of the SEC and, as importantly, Wall Street analysts. If, as the owner/CEO of a private company, you decide to take on new capital investors (either debt or equity), and you control (or are) the Board of Directors, then you can make that happen without any concern for other outside “constituents” other than your shareholders.
Do We Need to Factor Exogenous Variables into Our Decisions?
There will always be variables beyond our control – interest rates, inflation, changes in public policy, the weather, etc. And these variables can undoubtedly make some types of funding more suitable than others. For instance, you may think twice about taking out a loan if interest rates are high. A good financial manager will stay abreast of these concerns and aim to anticipate as much as possible when making decisions about your financial structure.
You may have noticed that most of these questions are typical for creating any strategic plan. And this makes sense because that is precisely what your financial leaders are doing. They are creating a strategy for how they will build the optimal financial structure to support your growth. So, they need to understand the big picture and review your history and plans before performing an analysis to determine what makes sense for you.
How Do Financial Executives Evaluate a Company’s Financial Structure?
Of course, as with most things in business, once you have decided on an appropriate financial structure, it is essential to keep things on track. So, I typically decide which data is relevant to a given situation then build those metrics into my monthly reporting process. Below are a few of the metrics I often monitor:
- Debt to Total Capital (Debt / (Debt + Shareholders’ Equity) = X%)
The debt-to-capital ratio provides insight into the riskiness of the company’s financial structure because it tells you what portion of the company’s liabilities consists of debt. In general, the higher this number, the higher the risk.
- Debt to Total Capital (Debt / (Debt + Shareholders’ Equity) = X%)
- Debt to Equity Ratio (Liabilities / Shareholders’ Equity = X%)
The debt-to-equity ratio tells us about the balance between a company’s debt and equity, indicating whether it could cover its debt with off-setting equities. Again, a higher number indicates risk.
- Debt to Equity Ratio (Liabilities / Shareholders’ Equity = X%)
- Interest Coverage Ratio (Earnings Before Interest and Taxes / Interest Expense = X%)
The interest coverage ratio measures how much cash you have to cover the interest you pay every month. The higher your earnings relative to your interest expense, the more flexibility you have to take on debt in the future, i.e., a higher ratio is more desirable.
- Interest Coverage Ratio (Earnings Before Interest and Taxes / Interest Expense = X%)
- Net Working Capital (Current Assets – Current Liabilities = $X)
A company’s net working capital metric essentially tells us how much capital it has on hand for short-term needs. So, naturally, we want this number to be positive. A higher number suggests that the firm has what it needs to fuel its growth, whereas a negative number could indicate trouble.
- Net Working Capital (Current Assets – Current Liabilities = $X)
I would caution you, however, against viewing these numbers in isolation. Ideally, you will track them over time and compare them to industry benchmarks to see the trends and determine what is normal for you. Also, for insight into the bigger picture, I like to pair them with other important financial metrics and KPIs, like gross margin and additional solvency and liquidity ratios.
The Bottom Line
The term “financial structure” refers to the balance of debt and equity a company has on its books, and it is a strong indicator of the company’s ability to achieve its goals. An imbalance means that the organization may be lacking the quantity and quality of fuel (money) it needs to keep its financial infrastructure operating smoothly. If you believe your financial structure is off-kilter, consider hiring a fractional CFO to diagnose the problem and get you on track.
