December Topic: Capital Structure

Evaluate your company's capital structure in order to assess its overall strength and stability, as well as to inform decisions about year-end distributions and bonuses.

At year end it is important to evaluate the strength and stability of the company, as well as to evaluate the capacity to provide end-of-year bonuses and distributions. This is accomplished by assessing the company’s capital structure. Capital structure includes short-term debt and access to cash, long-term debt, long-term assets, and equity—and these need to be balanced efficiently. See the following points for discussion:

• Excess working capital: How much working capital does the company need to begin the new year? This includes monthly burn rate, seasonality, etc. Excess working capital should be reinvested into the business or distributed to the shareholders, but the key is determining what the excess is. In the current economic environment this requires a strong focus on long-term strength and stability.
  

• Long-term debt: Long-term assets should be financed with long-term liabilities. Very often long-term assets are financed with short-term debt such as working lines of credit. This causes interest rates to be variable and consumes the company’s future liquidity. When balancing the company’s capital structure, this should be trued up.
  

• Long-term capital investments: Long-term capital investments are often made with cash. This is completely appropriate, but when the company is low on cash and utilizes its lines of credit, it is often more efficient to match long-term assets with long-term debt and preserve the cash for working capital/liquidity needs.
  

• Short-term investments: The most common short-term investment is the funding of accounts receivable. It is appropriate to utilize a working line of credit to fund this investment. However, it is important to focus first on the capital structure to make sure the company is operating efficiently. Very often there are long-term assets that can be financed more efficiently.
  

• Short-term debt: It is important to manage these facilities carefully and not allow them to become long-term financing tools. If the company has long-term needs, the company should finance long-term assets. If the company is continually leveraging long-term assets to free up line of credit capacity, it is usually a sign the company business model should be changed. Keeping a close eye on the capital structure in addition to the operating results can help the company see issues before all financing capacity is utilized.
  

• Economic cycle: Every seven years or so there is an economic downturn. It is important to optimize the company’s capital structure before new capital sources dry up. It is also important to maintain liquidity and company equity. This should be taken into consideration before distributions.

After evaluating the above and making needed changes/hitting appropriate ratios (such as current ratio/cash sufficiency ratio, etc.), if there is still excess working capital/liquidity it is important to assess bonuses for key company contributors, paying down vendors, and distributing capital to owners.