All forms of funding involve some degree of risk. A controller must be cognizant of all the forms of risk to ensure that management is made aware of the potential shortcomings of each one. Five types of risk accompany the use of various kinds of debt or equity [funding].
One or more will be present for virtually every kind of financing option, as follows:
1. Risk Of Not Paying Interest On Debt
If a company acquires more debt than it can support through the cash from its continuing operations, then there is a high risk that it will be unable to service even the periodic interest payments on the debt, which will result in either renegotiation of the debt with lenders or a default that can result in the liquidation of the company as a whole or the assets that were used as collateral for the debt.
2. Risk Of Not Paying Principal On Debt
This is a lesser risk than the preceding situation, because many companies simply roll their debt over into new debt instruments as soon as the old ones become due and payable. However, for those companies whose financial fortunes have significantly declined since the last time they acquired debt, there may be no lenders available who are willing to take the risk of issuing new debt to cover the now-due principal on the old debt. If so, a company can face dissolution or liquidation of any assets used as collateral.
3. Risk Of Experiencing A Loan Acceleration
Lenders sometimes have the option to force the acceleration of payments on debt owed to them. This is usually brought about by a change in the lender’s perception of the ability of a company to do business, such as a string of poor earnings reports. In such a situation, a company is obligated to pay off the debt by whatever means, such as a refinancing or liquidation of any assets used as collateral. If it cannot meet the lender’s demand, it may be necessary to take the company into bankruptcy.
4. Risk Of Tighter Loan Covenants
If a lender finds that a company is unable to meet its minimum loan covenants, such as a minimum current ratio or inventory turnover rate, then it can impose much more restrictive covenants that can actively interfere in the running of the business. Essentially, the lender can alter the company’s objective to be that of paying off the loan, possibly by requiring lender approval of major business decisions involving the use of cash for purchases of any kind outside of the normal course of business activities.
5. Risk Of Shareholder Revolt
Common stockholders own a company, and if they are dissatisfied with the existing level of return on their investment, then they can band together and replace the board of directors, which in turn can replace the management team. Thus, the consequences of not generating an adequate return for shareholders are severe.
At least one of the above five types of risk will apply to any form of financing. For example, the risk when using a lease is that nonpayment will result in the loss of the asset, while poor overall profitability can result in a new board of directors that may replace the management team. Thus, a controller must convey to management the risks of using each type of financing; this should be a continuing message to management as circumstances change, for the risks will rise if a company finds itself either unable to service its debt or provide an adequate return to investors.
There is a major problem with issuing common stock or any variation that gives any entity the future right to purchase additional shares of stock, because this can alter the balance of power in the ownership structure of the corporation. This is a particular problem when a company is owned by a small group that wants to retain ownership. In this instance, the owners will continually opt for raising funds through any source but more equity. When this happens, the only options left for raising funds are through the spin-off of cash from continuing operations, or by adding on more debt, which will eventually raise the debt/equity ratio to such a high point that creditors will be willing to lend more funds only if the interest rate is extremely high (because the lenders are risking their capital while the owners earn all the profits). The end result is a highly leveraged organization that is at considerable risk of failure if its cash flow drops to the point where it cannot cover its continuing debt payments.
This problem is at its worst when the ownership group is absolutely unwilling to bring in new investors and has no funds of its own with which to increase the amount of equity. Under this scenario, the owners do not even have recourse to the use of stock rights, which would allow for all current owners to buy the same proportion of new shares that they currently own. A lesser situation occurs when the current owners can contribute more funds, in which case the absence of other owners is not a problem, and new equity is brought in as needed. Thus, the control problem and risk as it relates to the acquisition of new funding is a combination of close control of an organization as well as the ability of the current owners to put more equity into a company as needed.