When the auditors come creeping around your office, and due diligence is underway, will you be prepared? By knowing your debt, your equity, and what part both play in securing capital, you'll be ready to answer the financial call.

The CFO keeps calling you to bring more IT financial reports down to the conference room. A man you’ve only just met that morning wearing a suit three times as expensive as yours wants to know what you spent on the network last year, and what it’s worth now. And you can’t get your job done for answering questions about the worth of some old 386 computers your people have stored in the warehouse.

If this scene is familiar, in all likelihood your company has survived an audit, probably in conjunction with being merged or acquired by another company. Even more likely, you’re an Internet start-up with auditors crawling all over your books, doing due diligence for your company’s potential investors.

Before they lend your company capital, they want to determine how much your company is worth, what kind of risk they may be taking, and what the potential rewards are. Here’s how to be prepared for them.

Capital components
Capital for IT ventures typically consists of two components: debt and equity.

The cost of equity
While the CIO doesn't usually think of equity as having a cost, it does. In the most basic of terms, the individual investors in a company have choices as to where they might invest. These alternatives all have different levels of expected return and risk. The higher the perceived risk, the higher the expected return.

An example might be when the management of the company decides to go to the public for the equity. By utilizing this opportunity, management may lower their cost of capital considerably, realizing lower earnings expectations to meet lower costs of capital requirements.

The costs of equity include the interest on the debt, the investors' expected Return On Equity (ROE), and the cost of obtaining the capital itself. Some of the cost of raising capital can be initially folded back into the debt or equity, but at the end of the day it is paid for with additional interest or less profit distribution.

Cost of debt
The cost of debt actually includes several different components. Among the possible components are loan origination fees, broker commissions, points, prepayment penalties (if one prepays later in order to obtain better terms from another source), legal fees (the borrower's and the lender's), appraisal fees, and interest. The component with the greatest impact over time is interest.

The story interest rates can tell
Investors and auditors closely examine interest rates for a number of factors. Many of these factors are quantifiable and can be easily measured. Things such as terms of the loan, interest rates at the time of the loan, and the source of funds are all considered. Also taken into account is whether the loan is fixed or variable. If the loan is one with a variable rate, the basis on which the variable interest rate moves and the range of fluctuation also need to be considered.

On the other end of the scale are more subjective issues. These include the lender’s perception of the company. (If a lender feels secure enough to offer a loan, the company must be solvent, right?) Auditors will add up the value of everything in order to get a handle on the ultimate value of the company’s collateral. Also examined will be the financial stability of the company and its principals. Senior management, including CIOs and other officers, will be scrutinized in an effort to gauge and somehow quantify the quality of the management of the company.

Relative costs
Aside from looking at debt coverage ratios and loan-to-value ratios, the lender or investor is going to consider all of the factors at some level. They will all ultimately affect the amount of the loan and the terms. Every aspect of the terms has a relative cost to the borrower.

For example, you’ve been told the new network migration will have to be put off for another year, yet manufacturing has been given the go-ahead to purchase its new bottling equipment. What gives? A dollar spent on the network is the same dollar spent on the plant floor, right? Well, maybe not. As you know, money spent from current resources is cheaper than borrowed cash.

The cost and availability of capital affects every aspect of competition in your industry in very fundamental ways. In the end, the CIO of a company with less capital cannot afford to make mistakes and has to maximize cash flow by being an excellent manager. The CIO of a company with more capital and higher returns can, of course, afford to pay premium rewards to its key executives and other staff.

For Further Information
The Cost of Capital Center

Venture Planning Associates’ Cost of Capital

CAPITAL is the total amount of money or other resources owned or used to acquire future income or benefits.CAPITAL BUDGETis the estimated amount planned to be expended for capital items in a given fiscal period. Capital items are fixed assets such as facilities and equipment, the cost of which is normally written off over a number of fiscal periods. The capital budget, however, is limited to the expenditures that will be made within the fiscal year comparable to the related operating budgets.CAPITAL EXPENDITURES is the amount used during a particular period to acquire or improve long-term assets such as property, plants, or equipment.CAPITAL GAIN OR LOSSis the difference between the market or book value at purchase or other acquisition and that realized from the sale or disposition of a capital asset.CAPITAL IMPROVEMENT is the increase in the total amount of money or other resources owned or capable of being used to acquire future income or benefits.DEBT TO EQUITY (also DEBT/WORTH) measures the risk of the firm's capital structure in terms of amounts of capital contributed by creditors and that contributed by owners. It expresses the protection provided by owners for the creditors. In addition, low debt/equity ratio implies ability to borrow. While using debt implies risk (required interest payments must be paid), it also introduces the potential for increased benefits to the firm's owners. When debt is used successfully (operating earnings exceeding interest charges), the returns to shareholders are magnified through financial leverage.Source:

Jack Fox is Executive Director of The Accounting Guild in Las Vegas. Fox has been assisting thousands of accountants and IT consultants in building their own successful businesses. He has also coached for effective leadership in IT functions of small- to medium-size enterprises since 1984. He is the author of five books, including the third edition of Starting and Building Your Own Accounting Business, published by John Wiley & Sons.

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