Optimal capital structure (often also referred as or optimal financing mix) is one of the basic things required for a sound business. It refers to the way how companies finance their assets, how much it costs them and what they risk with it. Generally speaking, we talk about payables financing (suppliers), debt financing (banks) and equity financing (shareholders).

Corporate finance theory often addresses financing through weighted cost of capital (WACC), signaling the minimum level of return on assets engaged for which the economic value of the company is not being destroyed. For a perfect capital mix, the WACC is the lowest and the value for shareholders is maximized.

Financing mix: Balancing debt – equity

The chart presenting WACC in relation to the D/E ratio is U-shaped. Right part of the curve (area where the D/E ratio is above the optimal levels) is much steeper than the left part, signaling the fact that being too indebted is a bad decision to make.

The risk-taking of creditors is by its nature normally limited and therefore the financing is relatively attractively charged … at least as long the company indebtedness is in the healthy zone. When the company bridges that zone, the creditors start demanding higher collateral, decreasing the days of receivables outstanding, seeking to securitize receivables with third parties and increase the prices of goods sold, increasing the interest rates for refinancing activities etc. In this phase the company is already operating on the edge, risking increased illiquidity threats.

Optimal debt level is a relative term

Interestingly, levels of a sound financial debt globally significantly varies and is very much correlated with the 1) attractiveness of the region for the investors and investment flows as well as 2) growth potential. As expected, the highest debt levels are in developed countries such as USA and Western European countries (roughly 60% D/E ratio; 7x-8x Financial obligations / EBITDA ratio), followed by the developing Latin American countries, China, African & Middle East countries (roughly 50% D/E ratio; 6x-7x Financial obligations / EBITDA ratio) and relatively poorly indebted Eastern European countries and India (roughly 40% D/E ratio; 3x-4x Financial obligations / EBITDA ratio).

Almost half of the companies globally operate without or with minimal (<10%) financial debt and from that perspective do not exploit their full value maximization potential. On the other side, the debt of larger companies is often above the industry averages, transforming the debt into the strategical competitive advantage. In this context, we sometimes also see marginal leverage buyouts (LBOs) cases, that due to the leveraged nature and long-time periods often generate some value on the debt side.

Access to the right financial resources is crucial

Financing resources are the prerequisite for the company to operate as well as grow – organically (i.e. own investments in PPE) or inorganically (i.e. through M&A). When the company is growing at a fast pace and the business is either working capital intensive or PPE investment intensive, the company needs to be able to sufficiently provide new sources of equity as well. Generally acceptable is that the more mature the company is, the easier it is to find, maintain and optimize the financial resources. Companies in the early stages of development therefore often need to seek the seed and venture capital, since their risks are simply too high for the standard and risk-averse (not risk-loving) creditors. Furthermore, also companies in the early and mid-developing phase with high growth potential often come across liquidity problems, if they are not efficiently gathering their financial resources.

Equity financing is on one side most exposed to risks, but on the other side also unlimited upwards in terms of reward, since all the potential profits go to shareholders.

To sum up things, in terms of value for shareholders, a sound mix is preferable. Liabilities (payables financing & debt financing) help the company to exploit the full potential of value generation, while equity normally serves as a buffer.

Despite the fact that most successful companies in the last decade generated their value mostly through digitalization and non-asset intensive growth, the financing structure overall is not losing on its importance. Quite opposite, the market is becoming more competitive, leaving less & less space for errors and non-optimal financing structure.

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In other words, EBITDA gives you an indication of how much earnings before interest, taxes, depreciation and amortization the company makes with all the invested capital. Negative number is a red alarm for a company, meaning that the company is facing fundamental problems with its operations.

Normally practitioners consider normalized EBITDA only (management adjustments, pro-forma adjustments and other adjustments), since one off events may sometimes represent a significant role.

Due to fast and easy use of EBITDA, the metric is dominating the financial world. Its applicability makes it a #No.1 indicator. Furthermore, it is often used in relation with debt, value and performance indicators:

– Leverage: Financial obligation/EBITDA

This metric measures how does the debt relate to the ability of generating the operational profit. It can be argued that a leverage > 4 is not acceptable for banks anymore.

– Interest coverage: EBITDA / Interest expenses

This metric measures the ability of a company to cover its interest out of its operations. It is obvious that a ratio <1 is not sustainable.

– Value multiplier: Enterprise value/EBITDA (EV/EBITDA)

This metric measures how the market values the firm according to its ability to generate operational profits.

– Performance indicator: EBITDA / Total revenues (EBITDA margin)

This metric is a relative indicator and offers a great way to compare the company performance with its competitors.

EBITDA is further developed into EBITDAR and EBITDARM in cases where costs such as rents, restructuring fees and management fees represent a significant amount. These is especially typical for retail industry, REITs, hospitals, etc.

Nowadays more and more financial practitioners are aware of the underlying interpretational problems of EBITDA. The metric that overcomes the disadvantages of EBITDA is the economic value added model (so called EVA model). Even though the model as such is more advance, it relays on subjective assumptions related to the cost of capital calculation.

Are you interested in boosting your EBITDA? Check our performance improvement services or contact us directly!

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The owners of a privately-held engineering company engaging in medium-size utility projects approached us in panic to organize the sales process and find a solution to provide the sufficient liquidity until the new owner steps in. The company was performing extremely poor recently and felt into serious liquidity problems. Revenues collapsed and levels of financial debt rose in three quarters of a year from sound indeptedness to 180% D/E and 10,3x Debt/EBITDA. Owners were 100% sure that the company is on the way to bankruptcy and were only expecting a small fee for it.

According to their opinion, potential buyers could be managers, currently leading the company.

Addressing the pain: Company worth in the context of value generation

Consilue approached the valuation in line with the top-down approach, which also included in-depth analysis of the industry. After careful examination, we figured out that the demand for projects is highly correlated with cofinancing activity of EU structural funds and the valuation date matched the transition between the two investment cycles. Furthermore, the size of the EU contribution for the next investment cycle was also significantly changed for the key markets the client used to serve in the past.

After understanding the reasons which pushed the client into liquidity issues, we performed the in-depth financial analysis. We broke-down business into individual projects and analyze and project the developments one by one. We figured out that the company is in fact expecting a good profitability in the following two years, they only need to re-focus their activity on more prosperous countries in the region. Furthermore, also a significant increase in the cash conversion cycle (mainly increase in accruals) already indicates better times and is in fact by its nature only temporary.

For decision-making purposes, we decided to simulate the generation of economic value by years with and without operational restructuring and improvement in profitability. The purpose was to show the shareholders the importance of the active involvement into the future business activities of the company.

Later on we performed also the corporate valuation based on going concern. Since we used market value as our base value, also successful operational restructuring was assumed.

Results: Company worth estimate done right

We have showed the shareholders that the market value on the date of valuation is in fact significantly above their expectations. They understood that they were played by managers to sell them the company for the cheapest possible price.

Despite the existing high levels of debts, we persuaded banks to support the company with the short-term liquidity injection and stand aside.

Client’s testimonial:

When estimating the value of the company we took the EBITDA and multiply it with a given multiple. That was so wrong and almost costed us millions. One truly needs to understand where the value comes from. In our case, it was generated from the change in net working capital (decreasing the accruals) in the first year and strong EBITDA in the first two years.

We are sincerely thankful to Consilue for showing us the right path. Now we are about to change the management and actively approach the operational restructuring.

Advisor’s thought:

Valuing a company requires a deep understanding of the business. Often the process reflects many interests and fast response – as in given case – which makes it challenging.

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The client is a small company, operating in the plastic industry, specializing in the next generation packaging solutions. The company works for prominent clients from cosmetic, chemical, food & beverage, pharma and medical industry worldwide. The company is about to expand its presence in the Latin America. As planned, strengthening the presence in the emerging markets would most likely result in the projected two digit growth rates and EBITDA margins.

The client has developed strategic partnership relationship with its indirect competition all over the globe. Intense cooperation resulted in cost synergies and sharing of a supplier-side know-how. The indirect competitor’s owner has experienced a serious financial problems and thus a decision to divest the business has been accepted.

Addressing the pain:

Firstly, the client has decided for a general overview of the indirect competitor’s past operations. Based on the preliminary findings, the client has decided to continue only with the acquisition process of the most valuable asset – the existing customer database.

Later on the advisor has prepared the client a revision of the competitor’s past projects and their profitability analysis. The findings served as a base for the determination of key variables and preparation of the financial projections, calculation of synergies and customer database valuation.

In order to be able to achieve the full potential as planned in the financial projections, the client has been advised to employ competitor’s key sales personnel.

Results:

The acquisition of the customer database and complementary activities are expected to result in significant revenue and cost synergies and geographic risk dispersion.

Client’s testimonial:

It is very important to be aware of the fact that valuing the customer database from the perspective of “as is” projections and from the perspective of our business (reflecting our business model) varies. It messages significant synergies. Furthermore, taking over customer database with key employees is “a must” – it is a good oportunity to gain new capabilities.

Advisor’s thought:

The client is about to gain short term and long term boost in its operations through new emerging market penetrations and risk diversification. Last but not least, fulfilling the sales capabilities gap will enhance the company’s position and its ability to compete with significantly larger global players.

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