The Essence of Strategy // The Essence of Profitability // The Essence of Marketing // The Essence of Funding // The Essence of Cash flow
Five by Five – Module 4
THE ESSENCE OF FUNDING
Every business requires investment in order to function. In the business language of The Financial Fence®, this investment is called ‘capital’. Examples of capital might be inventory, accounts payable or plant and machinery.
All businesses require some capital to function. How much capital your business requires will depend on the type of business you operate. However, regardless of the type of business you have, the more you grow your business, the more capital you are likely to need. The key aspect of capital is that it has to be paid for. How you pay for the capital in your business is the essence of funding. This one thing will have a significant impact on the success of your business.
All businesses require some capital to function. How much capital your business requires will depend on the type of business you operate. However, regardless of the type of business you have, the more you grow your business, the more capital you are likely to need. The key aspect of capital is that it has to be paid for. How you pay for the capital in your business is the essence of funding. This one thing will have a significant impact on the success of your business.
Let’s take at a simple example that most will be familiar with. The family home is a piece of capital. Now, how do most people pay for the family home? Do they pay in cash? Most often this is not the case. The most likely scenario is that people save for a deposit and then borrow money from a financier to make up the difference.
So in this example of a house, you would have two types of
payments for the house, which we call funding.
· Some of the individuals own money, which we call Equity.
· Some of the financiers’ money, which we call Debt.
The combination of the individuals’ money (equity) and the financiers’ money (debt) added together equals the capital (the house) that was purchased.
Capital and funding are the two key elements of a balance sheet.
In The Financial Fence® business language, these are expressed on a ‘financial post’. In business, a balance sheet is a milestone. It is a
snapshot of your business at a particular point in time and it shows
you how much capital you have and how you have paid for (funded) it.
For any business there are two key types of funders. Each is looking for
a different type of risk and therefore a different type of return on their investment.
1. DEBT LENDERS – Look for a Fixed and limited return.
This is expressed as interest and the business has no options around paying it. This debt must be serviced and this is the reason why you need to be careful when considering the amount of debt to take on.
2. EQUITY LENDERS – Look for a Flexible and unlimited return.
This is expressed as a dividend based on the profit made in a business. Here the business has a choice because the business does not HAVE to pay a dividend. In fact many business owners choose to leave money in the business to grow it, which means that they require less debt to fund any growth, or expansion plans.
The mix of Equity and Debt in a business is a very important, because part of this funding is interest bearing and the other part is not. When growing a business using debt funding, there can come a point where the interest cost is so high that the business cannot sustain the level of debt. This is why, when you look at a financial post, the only section that is below the ground is the equity. The equity in your business represents stability. The post needs to be well anchored, and this can only be done through equity.
For a business to grow, funds are required to pay for the increase in capital. It is a very rare business that can pay for its expansion out of profits alone, so if you plan to grow your business you will need to fund this growth. The most common source of ‘growth funding’ business owners turn to is debt.
Businesses that grow quickly with debt funding can find themselves with lots of total capital employed, but also a mountain of debt. It is vital if you are growing a business that you have a clear understanding of how funding works. You must have an effective system for monitoring, reporting and communicating with staff and other stakeholders exactly what is happening with the funding supply in your business. Failing to do this can spell disaster, even when there appears to be plenty of capital. If the growth in debt and associated costs of that debt exceed the ability of the business to service it, failure is not far off!
The essence of funding is to ensure that you secure an adequate supply of funds from an appropriate mix of debt and equity. You must have in place the capacity to meet the demands of business growth in capital requirements BEFORE you need it.
When you undertake One Sherpa’s full educational programme ‘Business Financial Mastery’, you will learn much more about how funding and capital go together in business, as well as how all operational activity connects one balance sheet to another. Using The Financial Fence® business language; your activity is shown on the rails that make up your financial fence. The financial rails (your activity) connect your financial posts (milestones) together. This gives a clear picture for you as to exactly what all your activity for the period has actually achieved.
So in this example of a house, you would have two types of
payments for the house, which we call funding.
· Some of the individuals own money, which we call Equity.
· Some of the financiers’ money, which we call Debt.
The combination of the individuals’ money (equity) and the financiers’ money (debt) added together equals the capital (the house) that was purchased.
Capital and funding are the two key elements of a balance sheet.
In The Financial Fence® business language, these are expressed on a ‘financial post’. In business, a balance sheet is a milestone. It is a
snapshot of your business at a particular point in time and it shows
you how much capital you have and how you have paid for (funded) it.
For any business there are two key types of funders. Each is looking for
a different type of risk and therefore a different type of return on their investment.
1. DEBT LENDERS – Look for a Fixed and limited return.
This is expressed as interest and the business has no options around paying it. This debt must be serviced and this is the reason why you need to be careful when considering the amount of debt to take on.
2. EQUITY LENDERS – Look for a Flexible and unlimited return.
This is expressed as a dividend based on the profit made in a business. Here the business has a choice because the business does not HAVE to pay a dividend. In fact many business owners choose to leave money in the business to grow it, which means that they require less debt to fund any growth, or expansion plans.
The mix of Equity and Debt in a business is a very important, because part of this funding is interest bearing and the other part is not. When growing a business using debt funding, there can come a point where the interest cost is so high that the business cannot sustain the level of debt. This is why, when you look at a financial post, the only section that is below the ground is the equity. The equity in your business represents stability. The post needs to be well anchored, and this can only be done through equity.
For a business to grow, funds are required to pay for the increase in capital. It is a very rare business that can pay for its expansion out of profits alone, so if you plan to grow your business you will need to fund this growth. The most common source of ‘growth funding’ business owners turn to is debt.
Businesses that grow quickly with debt funding can find themselves with lots of total capital employed, but also a mountain of debt. It is vital if you are growing a business that you have a clear understanding of how funding works. You must have an effective system for monitoring, reporting and communicating with staff and other stakeholders exactly what is happening with the funding supply in your business. Failing to do this can spell disaster, even when there appears to be plenty of capital. If the growth in debt and associated costs of that debt exceed the ability of the business to service it, failure is not far off!
The essence of funding is to ensure that you secure an adequate supply of funds from an appropriate mix of debt and equity. You must have in place the capacity to meet the demands of business growth in capital requirements BEFORE you need it.
When you undertake One Sherpa’s full educational programme ‘Business Financial Mastery’, you will learn much more about how funding and capital go together in business, as well as how all operational activity connects one balance sheet to another. Using The Financial Fence® business language; your activity is shown on the rails that make up your financial fence. The financial rails (your activity) connect your financial posts (milestones) together. This gives a clear picture for you as to exactly what all your activity for the period has actually achieved.