As liquidity tightens in the wake of global volatility and low oil prices, companies in the UAE should carefully evaluate their cash and capital structuring to achieve their long-term growth objectives.
One of the fundamental issues that companies’ key decision makers are facing is “what is the appropriate capital structure for my business?” A company’s capital structure is, in a perfect world, a carefully balanced mixture. It combines:
• Equity – financing provided by shareholders;
• Debt – bonds and loans provided by bondholders and banks;
• Hybrid structures – such as convertible debt and preferred shares.
Equity, debt and hybrid financing all come at a cost. Recent experience suggests that SME equity – glibly assumed by some to be almost cost-free – should attract a risk return of 20 to 25 per cent, suggesting that very few SMEs should choose an all- equity capital structure.
An optimal capital structure should help to ensure a company has the right amount of capital – having too much is better, but not that much better, than having too little – during both good times and bad. Creating a structure that adapts to changing business cycles is easier said than done. The evidence is clear to see in the increasing number of non-performing loans and a jump in the number of skip cases. These, in turn, are being met by higher provisioning for bad debts by local and regional banks, which exacerbates the liquidity situation.
A further complication is that insolvency – getting your capital structure fatally wrong – can lead fairly quickly to imprisonment.
A number of SMEs in the UAE are struggling to maintain cash flows. Getting the capital mix right is an important part of the solution. While the government continues to support the sector – with recent action to ease some of the financial burdens on SMEs through peer-to-peer lending platforms – macroeconomic conditions across the region are making cash flows harder to predict.
While BP has recently predicted a recovery in the oil price, it is understandably reticent to suggest when this might happen. Equally, conditions in Syria, Libya and Yemen, while perhaps inching towards some sort of closure, are not helping to build producer and consumer confidence – such a vital contributor across the region to positive cash flows.
Understanding a company’s financial situation before determining its optimal capital structure is crucial. As well as accepting that the cheapest source of funds is nearly always to implement internal processes that, for example, minimise working capital needs and preserve cash through cost controls, this should include a review of how any operating and financial leveraging might affect a company’s ability to make loan payments.
Key decision-makers should not hesitate to leverage relationships with suppliers, bankers and customers, as trade credit can be an effective way of bridging a short-term funding squeeze. A short-term loan can also be an effective, immediate and relatively cheap solution.
Notwithstanding these short-term solutions, the fundamental key is to focus on cash requirements across the business, including short and long- term needs for capital.
To determine whether a company’s working capital projections are reasonable, SMEs and their lenders are increasingly using sensitivity analyses, which can help business leaders better understand the effect of financial decisions and projections by incorporating fluctuating variables. A sensitivity analysis is an effective way of predicting the outcome of a decision if a situation doesn’t quite develop as expected – or at all. In the case of a manufacturing company, excess inventory and the ability to collect receivables might become more challenging, especially during a downturn. American Apparel, with 8,500 employees and net sales of US$600 million in 2014, filed for bankruptcy in October last year, with high levels of inventory cited as one of the main reasons.
Whether or not financial obligations can be covered should be part of the borrowing capacity determination. Companies with tangible assets, which are likely to retain their value and should quickly be transformable into cash, are likely to be able to borrow more and are likely to find it easier to raise debt. SMEs whose assets are more intangible, such as knowledge-based companies and internet businesses, are much less likely to be able to raise high amounts of debt financing. In the simplest terms, a company’s debt capacity comes down to its ability to repay debt and to support ongoing working capital. Certain types of businesses might be subject to a higher level of uncertainty concerning their cash flows, and should consider their ability to meet future interest and principal repayment obligations.
With very few exceptions, no company is immune from large drops in demand. Therefore, when evaluating debt capacities or examining restructuring options, companies need to ensure that they rigorously stress test any projections.
If a company decides to access capital markets, knowledge is key. The finance director, or the nearest equivalent, needs to understand the various capital providers, as well as appropriate market terms and pricing in each layer of a capital structure.
A better understanding of risk and debt markets should lead to a more appropriate loan structure and pricing model. As we have seen, the risk of adopting the wrong capital structure can be severe. On the other hand, optimising the capital structure to match a company’s needs and possible market developments can add significant value. The ideal structure can not only limit the risk of default but may also substantially increase profitability and shareholder return – underlining the vital significance of getting the capital mix right.
Ashish Dave, is a KPMG partner based in the UAE