"Using the wrong capitalisation structure can severely impede your operations and stifle growth ambitions."

Capital structure is the proportion of debt and equity used by a company to finance its operations and growth. It includes short-term debt, long-term debt and common stock.

Debt consists of borrowed money that is paid back to the lender (typically with interest), whereas equity consists of ownership rights in the company, without the need to pay back any investment.

When financing any growth project, it is important to use the appropriate funding facility. Having an imbalanced capital structure could lead to the business struggling to make debt repayments, accessing capital investment, or not yielding the required equity expected by shareholders.

What are the key indicators?

The following financial indicators can help you identify if your business has an inappropriate capital structure, allowing you to spot warning signs and prevent any long-term damage:

1. Debt/equity imbalance (excessive gearing) creating unforeseen creditor and counterparty issues.
2. An increase in retained losses.
3. Excessive dividend extraction which is depleting reserves.
4. Unrecognised revaluation reserves.
5. Insufficient cashflow generation to service debt, resulting in covenant breaches.

Team collaboration

When operating with an inappropriate capital structure, it is vital that your key functions work collaboratively together.

Managing Director / CEO

The Managing Director/CEO needs to take control of the emerging situation by reviewing with the FD the current balance sheet to identify key structural issues.

The MD/CEO should also assess existing funding documentation to establish the options and understand the penalties which a lender might impose. It is worth spending time identifying whether there is scope to improve cash collection e.g. has there been a change in creditor payment terms or lax debtor control? And evaluating dividend levels and their appropriateness in current circumstances can help improve the situation.

Finance Director

The Finance Director needs to take responsibility for identifying internal and external solutions to protect cash flow by assisting the MD with data gathering and root cause analysis and reassessing current cash flow to see if there is scope for improvement.

A key priority for the FD will be Identifying whether there are any undervalued assets which could improve reserves and preparing a summary of all financial instruments for internal review to fully understand what risks the business is likely to face.

Sales and Operations

The Sales and Operations teams need to support the MD and FD by expediting delivery of long-term projects to minimise cash flow pressure and maintaining strong sales and marketing efforts to drive demand for products or services to boost revenue.

Key points

In summary, try and consider whether this is a short-term issue or a fundamental balance sheet problem that needs to be resolved. Also consider how to approach affected parties and the basis on which their support should be sought. It is worth reviewing whether there is scope to restructure your debt stack to reduce reliance on cash generation. And always consider equity raising options.

I hope this article has provided some useful tips on what may trigger cash flow problems when inappropriate capital structures are used and how your teams should work together to mitigate any long-term damage. See how we helped Ensilica UK overcome a similar situation in the success story below.

We work with growing UK SMEs and small-cap PLCs that have funding needs in excess of £2m and regularly approaching £100m. Our clients’ needs will typically be for sophisticated finance products such as cash flow based lending or private equity investments. Our value lies in helping clients access funding that relies on confidence in future trading and cash flows. For a confidential, independent, no obligation discussion on the funding options available click the 'Let's chat' button.