Cheat sheet: simplified lessons in Finance for the newbie entrepreneur
One of the key factors for a sustainable business is keeping track of how finance is managed. The degree of risk associated with this factor gets even more magnified in the entrepreneurial world,as entrepreneurs do not necessarily walk through the hall of fame with a swashbuckling qualification in finance. Entrepreneurs are impulse-driven. Many entrepreneurs even take it upon themselves to manage the finance of the company until they find a suitable teammate who can look into the holy grail of the company’s future. They learn finance the hard way, through experience and advice from their mentors, but in most cases this information comes in only when the mistakes are made.
No one can discount the lessons that can be learned from making mistakes. However, the gravity of mistakes made can determine how much time is lost in making an important decision that will make a lot of difference in today’s world.Time is of the essence, because every entrepreneur wants to not only grow but to grow quick. Being the finance in-charge for a startup myself, a relative inexperience in these matters when we started out made me learn this the hard way.
In any business project, the idea is to invest an X amount of money and obtain X+a certain percentage of return. The two legs, X amount and percentage of return, can be classified as capital transactions and revenue transactions respectively. Revenue is generated through adequate investment of capital. Raising capital can be tricky if the basics of types of capital are unclear.
Capital transactions are broadly classified into the following :
1) Equity: This refers to the owner’s capital. However, in an entrepreneur’s world, this does not mean only his capital because his investment is generally negligible, which means he needs a partner who can invest in equity capital. However, in most cases, this partner is going to be an investor with a risk appetite that is higher compared to other forms so that he can have a larger pie of the returns when they are generated. A point to be noted is that equity consists of everything: share capital, profit or loss balance, securities premium, general reserve, etc.
2) Long-term debt: Long-term debt is generally for someone who has a lesser risk appetite, as a result of which the return is also fixed. The lender generally (but not necessarily) also requires security in the form of an immovable asset which the lender can take control of if the borrower is unable to service the terms of payment. Long-term debt is crucial for the financial success of the project which I will come to later in this article.
3) Working capital: This form of capital is generated/raised in order to manage the short-term gaps between generation of revenue and incurring expenditure. Again, a low-risk finance provided generally (but not necessarily) with security attached.
If you have noticed, all of the above are classified based on risk identified with the form of capital. Risk generally has one meaning.However, the perspectives from which an investor and an entrepreneur look at itvary. For an investor who has been asked by an entrepreneur to invest in his business, it is the cost of capital that the investor will match with his expected return, which in turn will entail his investment decision. However, for the entrepreneur the risk is associated with the application of the capital and the certainty with which that amount will be recovered in the future. Therefore, it is crucial to understand how each form of capital needs to be directed through operational transactions in order to reap the most efficient and effective benefits out of them. I have given a detailed justification for each of them below. Before that I would like to make two things clear:
1) All of us picture a balance sheet in mind when we think about capital. I would request you to clear that for now. A balance sheet is a mere presentation of the financial position (historical worth) of the company at a given point in time. It is by no means an indicator as to what finance is required. What decides the type of capital required is the time horizon and the nature of costs to be incurred with respect to the business project.
2) Keeping the above premise in mind, a business project has to be looked at from the perspective of inflow of cash, utilisation of the cash to generate revenue (expenditure), recovery of the cash invested and generation of additional cash (revenue) for value added. Therefore, all the cash used is, in essence, expenditure, so even though we capitalise assets, the assets have a terminal value which will either be consumed in generating cash or will be discarded at the end of the project and generate equivalent cash. The net difference at the end of the project is the cumulative returns on the initial investment.
Now lets get to business:
1) Equity: Equity is a long-term investment and generally attached to a high risk. In other words, as far as the entrepreneur is concerned, this capital is to be applied in cases where the recoverability is uncertain. Expenditure such as research, product development, marketing, advertising, remuneration to core team members, even deep discounts, set up costs and other initial costs that are required to get the ball rolling for the business are classic examples for application of equity capital. The reason for this is because such costs are crucial to the revenue generation activities but their risk of failure is high and at the same time the potential of return is indefinite. There is no restriction in using this capital to other forms of expenditure, but there is an additional benefit of using other forms of capital (primarily debt) that are compensatory for the risk borne by the equity shareholder.
In essence, equity is best suited for expenditure to be incurred when the entrepreneur ascertaining the viability of the business model/product or is laying the foundation or chasing the highest market share, and also when other forms of capital are inaccessible. It is also worth noting that all the profits made by the business which are re-invested are also forms of equity, and if not paid out as dividend, its application is the same as above.
2) Long-term debt: Long-term debt is for the proven business, one of the reasons why it is not the buzz word these days. However, long-term debt is good at one thing:scalability. If the entrepreneur knows that the business is a success at the pilot stage and now seeks to take it to the next level, long-term debt plays a crucial role. Primarily, because the risk attached with long-term debt is low and, therefore, since many types of expenditure are regularised and the time horizon is definite, the certainty is foreseeable. High capital outlays such as setting up of a factory or a service centre, and infrastructure costs can be funded through long-term debt. The major plus point of this is that it provides leverage to the equity investors. As a result, the equity investors get a bigger pie of the returns, because long-term debt does not partake in the profits more than the pre-defined interest rate. However, long-term debt cannot be mismanaged. A key risk associated with long-term debt is accumulating large amounts of debt and then being unable to generate enough cash flow to service the same. In essence, debt creation is like trying to finance the future at present but with a promise to return it, which is not the same with equity. Therefore, increased piling of debt without generating enough cash flows to service the same can be extremely dangerous for the business. Long-term debt in most cases needs to be backed with security which is why it is suitable for infrastructural expenditure as mentioned above.
3) Working capital: Working capital is the litmus test of a well-oiled machine. If your working capital is managed efficiently, then it is the mark of a good finance manager. It is like the gear box of a business. As the name suggests, working capital is associated with the risk at the operational level of the business. Generally, there is gap between the creation of a single unit of the product at sale and the final delivery of the same to the customer. Funding this gap with equity means you are losing out on the opportunity of using equity for other long-term objectives. Long-term debt is long term, so what is left is a short-term source that will fill the gap. The best source of working capital is credit period from the supplier, equivalent to the time it would take you to provide the final product/service. If that is not possible, then there are other measures such as overdrafts, cash credits etc. Maintaining optimum working capital is key. A classic example is inventory. Unnecessary accumulation of inventory not only widens the working capital gap resulting in a higher cost to the company and lesser chunk of the returns flowing to the equity investor, but also means that the entrepreneur is unable to sell enough stock as a result of which the turnover gets affected. Which is why maintaining a good inventory to turnover ratio is extremely crucial to any product-driven business, especially trading concerns.
The bottom-line is that there is a project which needs money. Money in the form of 'equity only' will result in a capital outlay with a specific return. However, replacing that capital outlay with other forms of capital wherever possible increases the returns for the equity investor. In today’s world there are various options that are alternatives to equity. It is a matter of how well you can plan and manage your capital requirement.
It is essential to stick to basics, which is the objective of this article. Most entrepreneurs who start out on their own find finance extremely difficult to understand. Many of them go knocking on the doors of VCs and Angels and then come back empty-handed because they do not understand the kind of finance required by them. This is for them.