We will continue the Financial Advisory Series by talking about how to review your financial capital strategy this week
Overview
Financial Capital is the term used to describe money raised for a firm. In economics and finance, however, the term "capital" has a variety of connotations. The terms financial capital and capital (factor of production) should not be used interchangeably. Financial capital is frequently misunderstood as the fifth factor of production, which it is not.
Financial capital's primary job is to make output available and to successfully operate the company's activities while also providing profits. Financial capital is wealth that has been saved and is utilised by firms and people to raise income or invest. It is used to keep enterprises running smoothly. Financial capital is viewed by businesses as a type of investment capital that aids in the generation of future revenue as well as the provision of goods and services.
How financial capital is acquired
Debt and equity are the two most common forms of financial capital. Peer to peer loans, business card loans, invoice loans, and other sources of financial capital exist in addition to debt and equity.
When you were establishing a new business, you would want to evaluate the strategy that is right for you. The decision is frequently based on the company's most readily available source of capital.
To obtain finance for business purposes, most organisations employ one or both of these strategies.
Debt Financing
Equity Financing.
Debt financing
Loans are the most popular type of debt financing and are repaid with interest. This is sometimes accompanied with constraints on the company's actions, which may hinder it from pursuing outside possibilities that are unrelated to its main business sectors. If the company needs to obtain additional debt financing in the future, a relatively low debt-to-equity ratio will benefit the company.
Advantages
The lender has no authority or influence on the company.
When the loan is paid off, the connection ends.
Because loan payments do not fluctuate, it is easier to estimate spending.
Disadvantages
The monthly expenditure is still expected to be paid even if the firm does not grow quickly. This might cause the company to become stagnant.
A guarantee or collateral for the loan, such as property or stock, may be required by the lender.
Equity financing
The sale of a company's stock in exchange for funds is known as equity financing. The term "equity" refers to a person's direct involvement in a company. When someone invests N1,000,000 in a company in the expectation of earning a share of future profits, the company's equity capital increases by N1,000,000. The majority of equity capital does not come with a promise of future profits. When a business owner sells 30% of their company to an investor in exchange for financing. The investor now owns 30% of the firm, while the owner now owns 70% of the company.
Advantages
There is no responsibility to refund any money earned or received because of it.
The firm is not burdened in any way by this kind of funding.
Disadvantages
You would have to give up a portion of your firm to get the money.
Before making any company-related choices, you must confer with the investors.
The only way to get rid of the investors is to buy them out, which will almost certainly be more expensive than what they paid you.
Reviewing your financial capital strategy
Analysing your company's capital structure is part of reviewing your financial capital strategy. The combination of equity and debt on a company's balance sheet is its capital structure. A prudent use of debt and equity is a vital indicator of a healthy balance sheet and a sign of high investment quality.
Various financial ratios aid in the analysis of a business's capital structure, allowing investors and analysts to assess how a company compares to its peers and, as a result, its financial status in its industry. However, the three most important financial ratios for evaluating a company's capitalisation structure are:
The debt ratio which is calculated as total debt to total assets
The debt-to-equity (D/E) ratio which is calculated as total debt divided by total shareholders' equity.
The capitalisation ratio, which is calculated as (long-term debt divided by (long-term debt + shareholders' equity)) and provides important information about a company's capital status.
The combination of equity and debt on a company's balance sheet is its capital structure. Lower debt levels and higher equity levels are desired, yet there is no exact level of either that indicates what constitutes a healthy corporation.
Unfortunately, there is no such thing as a magic debt-to-equity ratio. What constitutes a good debt-to-equity ratio varies depending on the industry, line of business, and stage of development of a company.
Email us at: enquiries@ovacgroup.com for a free consultation with our team specialists.