Now I’m not taking you back to 1958 for an analysis of the thoughts of Modigliani and Miller and their computations on well-crafted formulas. Rather, what we have here is simply lighting up an awareness of the money you have deployed in your business and getting you to have an introspection of what you have made of it.
What is Capital?
Since I’m trying to break everything down in digestible bits, I’m going to say that capital is money put into your business and everything that money can do for you in your business. In other words, the money you put into the business can be used to rent a store, or to buy machinery, or pay for the time of your human resources or to set up office space and so on.
What about Cost of Capital?
Typically, many SMEs start the business with money from their accumulated savings and also expand the business with profit retained over time. This is because the barriers to accessing loans could be very high, especially with the need for tangible collateral requested by institutional lenders such as banks.
Whatever the source of money you are injecting into the business, it has a cost.
If you are getting funding from your savings or from other individuals who want a stake in your business, we refer to this as Equity Capital. The cost here can be seen as two-fold. There is first the stake in your business that you have to part with if you are getting equity funds from other parties, and then there is the opportunity cost of your own money injected into the business. With opportunity cost you are considering, what else other than your business could you have put your savings into that would generate a return? Would this return be higher than the current return your business renders?
For the institutional lender, their required interest rate on the money they are providing your business becomes a cost to your business. That interest rate is the cost of capital in the instance where you are borrowing money from your bank to fund activities in your business.
What is the correlation between Cost of Capital and Financial Performance?
Financial Performance identifies how well a company is doing in generating revenues, how it is managing its assets, and also its liabilities.
Every business owner should be interested in knowing if the business is a waste of time or if it has great prospects based on what current performance indicates. While it is true that at the beginning many businesses do not turn a profit immediately, there need to be indicators as to what brighter future lies ahead for the business. An understanding of customer requirements and how to fulfill them would be very critical here because having the heart of customers could easily translate to an upswing in revenues. We know that as long as we can keep revenues higher than total expenses, then the business remains profitable.
Logically, if interest costs are high on funds used in trading, that cost needs to be transferred to the end user, the customer, in a bid for the business to meet up its obligation with the lender and repay as and when due. What this implies is that sales price is affected. If you are not selling ostentatious items (luxury goods) which typically have inelastic price elasticity, then in all likelihood, customers are going to react adversely. They will switch to a seller who is selling at a lower price. If this customer switching pattern becomes significant, then of course the business takes a hit, as lower revenues would consequently translate to lower profits or in some cases, losses. This is resulting from the fact that the business is trading with very expensive funds.
Should all SMEs bear the same interest cost?
There just may be a need for lenders to pay closer attention to the varying patterns and peculiarities in the financial performance of different business segments. The business owner in retail fashion should not be paying the same interest rate as the business owner rendering outsourced human resource services. Their capacity to generate revenues differs and so do their profit margins. So why the one-size-fits-all interest rates? Of course, this may be asking lenders to invest in deeper research if their objective is to really support SMEs to scale up.
The point is that interest costs should allow the business to breathe, and not leave them in an endless loan cycle where they repay the loans and have to take them again almost immediately because their business can really not afford the cost of the loan and it does not leave them with sufficient profits to plough back in expanding trade volumes.
Should operational decisions be influenced by cost of capital?
Everyone in management must be mindful of the need for business sustenance. The business has to be able to repay its obligation to lenders as and when due or it goes bankrupt. To this end, cost-efficient decisions across all departments need to be implemented. Whether it is Marketing, Supply Chain, or Logistics, the thought process should be opting for the decision that minimizes costs without compromising quality.
In concluding, let me say that some people are going to have a better advantage than others when it comes to cutting down their sales price simply because they have a cheaper cost of capital. We have witnessed businesses get cheaper loans overseas and the advantage it gives them over those whose funds are from institutional lenders in Nigeria. It would mean that as a business owner you may not be able to compete on price alone in such a situation. Other distinguishing factors would need to be emphasized to get a decent share of the market.
Here’s wishing you the best on your journey to immortalising your business!
