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Home > Balance Sheets Best Practice > Corporate Finance for SMEs

Balance Sheets Best Practice

Corporate Finance for SMEs

by Terry Carroll

Executive Summary

  • Corporate finance has evolved over many years to become a sophisticated specialism, for which the fees may be substantial.

  • The principles are the same for SMEs (small and medium enterprises) as for any larger company.

  • Often transaction-led, it is recommended that a wider full balance sheet approach be adopted because of the strategic financial significance.

  • SMEs often originate as owner/proprietor businesses, and this structure can often trigger transactions such as change of ownership or disposal for tax purposes.

  • By applying the same basic principles, there is no reason why similar sophistication should not be available to SMEs at affordable rates.

  • Working capital is a fundamental need in a recession. In order to survive, SMEs should strategically review and simplify the business, exploring all available sources of capital.

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Introduction

The term “corporate finance” is widely, and sometimes loosely, used in business. In accounting firms it typically relates to a department or function that primarily deals with:

These might represent the practical application of corporate finance. In theory, however, its primary role is to maximize the value of the business while minimizing the financial risks. The essence of the present article is that the practice of corporate finance has become oversimplified—potentially to the detriment of the business.

Furthermore, while corporate finance is usually a specialized department in larger accounting firms and in some smaller ones, its application in SMEs can often be quite different. Here, accessing and managing sources of working capital becomes a fundamental need, especially in a recession.

We shall propose a wider approach to corporate finance, based on asset/liability management principles and the full balance sheet approach, that is just as applicable to SMEs as it is to larger, more sophisticated companies.

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A Full Balance Sheet Approach

A full balance sheet approach is recommended as the underlying principle of applying corporate finance. This involves looking at each and every asset in the context of the liabilities that actually or notionally finance them. Two key measures are:

  • The amount by which the profit would increase or decrease as the overall result of a 1% change in interest rates.

  • The difference between the average duration (i.e. asset life weighted by value) of the assets and the average duration of the liabilities that fund them. The importance of this is that, if the duration of the liabilities is shorter than that of the assets and, for example, interest rates rise, there will be an additional cost to the profit and loss account that cannot be recovered by the assets.

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A More Sophisticated Approach to Corporate Finance for SMEs

SMEs are often started and/or owned by owner/entrepreneurs. Corporate finance transactions may be precipitated by owners, their bankers, accountants, or lawyers, or by approaches from elsewhere. For example, two sets of circumstances have recently led to a flurry of transactions:

  1. The British Government changed the capital gains tax (CGT) arrangements for businesses from April 6, 2008, ending taper relief. One result was that, leading up to this date, accounting and law firms were deluged by a spate of entrepreneurs seeking advice on financial restructuring or sale of their businesses to children, managers, and other interested parties so as to minimize CGT.

  2. A growing number of owner/entrepreneurs are approaching retirement age and want to pass their businesses on to their children or managers.

Both of these typical situations create the need for advice and support on corporate finance, funding, and tax and legal advice.

The transactions referred to in points 1 and 2 are circumstantial. Other typical examples are refinancing the business, management buyouts and buy-ins, and M&A. These are routine corporate finance transactions, but if we return to the theory and apply it there are many more sophisticated possibilities which can be more appropriately driven by business or financial strategy, rather than circumstance. One of the less obvious times to consider these is during a recession or economic slowdown.

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Business in Three Boxes

Entrepreneurs who have started their own business often end up trying to juggle all of what are known as the “three boxes,” though such a simplified approach is entirely appropriate in a recession. The three boxes are:

  • business development, which includes both sales and marketing and the development of the business itself, whether organically or by acquisition;

  • operations, including delivery;

  • finance and administration.

It has been possible to outsource the last of these for at least 20 years. Not every business can afford or justify the appointment of a full-time finance director, but even that function can be contracted out these days at an economic cost—creating the “virtual F.D.”. By doing so, the entrepreneur is able to focus on those aspects where his or her skills and experience are usually best applied—in the first two boxes. These should go hand in glove, as together they represent the “end to end” customer-focused processes.

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Recession, Review, and the Application of Corporate Finance

A recession or similar downturn is absolutely the time to do a root and branch review, “lift the drains,” and spring-clean the business. Why? Two reasons: First, because you have more time to do it during a recession; and second, because having done so, you will emerge lean and mean when the economic cycle turns favorable once more.

So often, corporate finance is transaction-led. Most accountants routinely offer the corporate finance services listed at the top of this article, but (and not just in the application of theory) there are many more opportunities, both holistically and in detail, to add measurable and lasting value to the business—and better understand it—if a corporate finance transaction starts with strategy and a thorough business review.

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Business and Financial Reviews

Any accountancy firm worth its salt can do a financial review of sorts. This would probably focus on the profit and loss account, or tax, and how you can thereby save money. But the central focus of corporate finance is much more on the balance sheet. For example, an acquisition needs financing, either by debt or equity, or by both. Both need to be seen in the context of and integrated into the existing financial structure of the balance sheet.

A thorough financial review should ideally begin with a thorough business review. Every financial transaction is the consequence of a business decision. The business review starts with a review of strategy—especially the marketing strategy. It can go all the way through to the business processes and the systems that support them.

It’s rather too simplistic to think that corporate finance transactions result solely from a need such as raising more working capital, financing capital expenditure, saving tax, selling or passing the business on, etc. Even if these are the circumstances that trigger a corporate finance transaction, each transaction should still be preceded by a thorough business and balance sheet review to see how it fits into the whole and ensure that the overall goal of maximizing the return on the balance sheet at a managed level of risk can be achieved.

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Corporate Finance in a Credit Crunch

Credit shortages and squeezes are not unusual; they typically follow a credit “bubble,” where credit has grown so fast that it necessitates an economic readjustment. More importantly, the recent credit crunch has actually been a liquidity shortage. Funds have been scarce and the cost of borrowing has gone higher because the banks could not raise sufficient, or even any, longer-term funds to lend to business.

The smaller the enterprise, the harder it is to raise sufficient funds and the higher the likely cost. It’s hard enough that the economic slowdown has squeezed financial performance. Being unable to find additional funds readily when they are most needed can all too often lead to business failure. It’s not lack of capital but lack of cash that busts businesses. So creativity in corporate finance becomes even more important.

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So What Can SMEs Do?

Few SMEs have the opportunity to float via either an Alternative Investment Market (AIM) or full listing on the London Stock Exchange. Furthermore, the new issues market is unlikely to return to anywhere near normal before 2010. Most corporate finance transactions for SMEs involve rather less finance than might be raised through an IPO (initial public offering, or flotation).

One factor that unites all SMEs is the need to find and manage working capital. Many are wedded to the idea of unsecured debt—usually an overdraft. Some will even resort to moving banks just to get a bigger unsecured overdraft facility.

This may not be the most efficient or, especially, the cheapest means, however. The credit crunch produced some fundamental changes in the commercial and corporate banking markets (many UK bankers refer to finance for companies with turnovers of up to $1.5 million as “commercial” and above that level as “corporate”; there is no real difference in principle). First, it accelerated the transition from overdraft finance to invoice discounting. One of the key reasons for this was because in most cases banks wanted security for the debt.

This security can take many forms. The most common is assets—property, machinery, other capital assets, cash, stock, receivables, etc. The practice of taking unsecured personal guarantees has decreased, but banks may routinely ask for a statement of personal assets and liabilities. Ideally, they prefer to take a charge on personal assets, such as the owner’s or director’s house.

Parallel with these changes has been the move away from base rate related finance. At the worst of the credit crunch, Libor (the London Interbank Offered Rate, i.e. the rate at which banks lend each other money) diverged by up to 1.6% from base rate (usually equal to the Bank of England Base Rate as reviewed and set by the FOMC monthly), so banks preferred to use Libor as the basis for their lending rates. It also allowed them to blur the edges from one bank to another, as opposed to the common metric of the base rate.

So unsecured overdrafts became relatively dearer (up to 5% or more above base rate) and invoice discounting relatively cheaper (as low as 1.2% over base rate, although it rose as high as 2% above as Libor diverged).

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The Cheapest Form of Working Capital

The cheapest form is that generated by the business itself, i.e. from sales. It is amazing how many SMEs approach their advisers or bankers seeking to borrow more money for working capital purposes when they could devote more time to selling and less to administration. This is the principle of working in the business rather than on the business. Sir Alan Sugar, the British entrepreneur and businessman, is not alone in referring to the concept of the “busy fool”—someone who works long hours and makes little or no profit.

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Other Forms of Funding

Beyond sales and shorter-term borrowing, banks offer several other forms of financing, at various cost levels:

Asset-backed

  • property finance;

  • asset finance, including leasing, HP, etc.;

  • stock finance.

Quasi-secured

Unfortunately, as the credit crunch deepened, the availability of finance fell and the price increased. In particular, property finance became scarcer, with much lower loan-to-value (LTV) rates, as banks found they were yet again overcommitted to commercial property finance less than 20 years after the last property crash.

In summary, therefore, funding has always been available for well-run, profitable companies of any size generating regular cash flows and with assets to act as collateral. With little interbank lending taking place, resulting in shrinking wholesale funding and a liquidity squeeze, it has been no surprise that banks in general became more cautious about the scale and security of their lending.

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Transaction-Based Corporate Finance

As in the wider markets, M&A activity has slowed dramatically, due both to a shortage of funds and to the greater overall perceived risk of corporates in a slowdown. In the case of both M&As and management buyouts/buy-ins, the transaction is primarily based on the track record of sales and profit generation and the capability of the business being acquired.

The more doubtful the recent and projected profit record, the more likely it is that the majority, if not all, of the funding will need to be based on assets and/or quasi-assets.

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Tax, Legal, and Professional Advice

Some may think that corporate finance is an industry invented by professionals to generate fat fees. However, there are many pitfalls in trying to do it yourself. The finance director or owner is generally unlikely to get the best terms possible, even if they run a competitive auction.

Professional advisers, such as the accountancy firms, will usually have better and more banking and financing contacts. They should also be able to exert more leverage on the banks, as they have their whole clientele as the lever, rather than the business and assets of a single company or business.

Many people also resent paying what they regard as high or exorbitant fees, especially to lawyers. While there may be the odd less scrupulous professional adviser, in the main you will be paying for massive accumulated experience of the best and most efficient ways to source, transact, and document the finance, as well as avoiding myriad pitfalls.

While sale and purchase agreements and shareholder agreements may have a standard form at their core, each company and set of directors is different. Finally, there will be tax implications for every corporate finance transaction, whether for the organization or the individuals concerned. If you have the right advisers, there is no harm in taking a degree of responsibility on yourselves, but your advisers can save you money and help you avoid penal costs and consequences.

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Conclusion

Corporate finance can mean different things to different people; even the banks divide it into at least three categories: commercial finance, corporate finance, and structured finance. In truth, however, it is about just one thing—how the business is financed. The key is the whole balance sheet approach, looking not only at the optimum mix of short- and longer-term finance, but also at the overall picture: which liability funds which asset, at an optimum balance of cost and risk.

At its best in practice, corporate finance can be a sophisticated science. This does not make it any less applicable to SMEs. While the scale and nature of transactions may often be smaller or simpler, there is no reason why similar principles and practices shouldn’t be applied. Equally, for firms that have the necessary breadth of skills, the fees do not need to be exorbitant either.

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