Equity Capital: In Conclusion
July 29th, 2010
Copyright © 2010 Integrated Profitability TM
To summarize this series:
● Equity = assets – liabilities
● Investors provide initial equity
● Equity grows by the amount of positive net-profit that is invested back in the business
● Equity allows a business to grow and invest in itself
● Equity is a cushion to handle inevitable financial stresses in business
● A prudent amount of equity to have is the amount needed to cover a full year of your business’s potential, combined net-losses
The “Small Business Finance & Profitability” (SBF&P) series on Equity-capital started with this question from a reader:
“Good! Finally all of this is coming together for me. How about more on capital? What is it? where does it come from, is it actual & stored somewhere physically and separately or virtual like the net or sum of two or more numbers?”
After an unintended tangent (Capital: Mea Culpa), here’s the answer to the last question:
● Equity-capital is the result of “Assets – Liabilities”
● Both assets and liabilities have an actual, a physical nature
- Assets: cash can be held in your hand; equipment is surely physical
- Liabilities: loan papers are signed; invoices create Accounts Payable
Equity-capital, however, is not tangible in these ways. It is, in fact, “…virtual like the net or sum of two or more number…”
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 73
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
Equity Capital: Where’s it at?
July 22nd, 2010
Copyright © 2010 Integrated Profitability TM
At the end of the day, if the negative pressures on your company’s profit require you to access the equity-capital you built up over the years, where’s it at? How do you tap that safety net?
Liquidate assets
Basically, you draw down your assets to pay for the negative profitability that is pounding your company. The first asset, of course, is “Cash”:
● Use cash to pay expenses
● In order to keep the Balance Sheet in balance, equity-capital will decrease
(NB: let’s ignore the complicating reality that many of these transactions will flow through “Accounts Payable” liabilities first. The point here is that eventually, when revenue is less than expense, equity-capital will ultimately be used to fund the negative net-profits).
Assets have different liquidity characteristics. With the most drastic scenario, equity-capital is accessed by liquidating all assets and using the proceeds from those asset sales to pay off all liabilities (or as many as can be paid off).
Whatever is left is equity-capital: positive or negative.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 72
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
Equity Capital: Intriguing Weirdnesses
July 15th, 2010
Copyright © 2010 Integrated Profitability TM
Near the beginning of this series on equity- capital, Equity Structures: Market Examples & Other Names for Equity went over the basic components of a company’s equity structure. In the beginning of a company’s life, the equity part of the balance sheet is straightforward:
● Preferred Stock (if issued)
● Common Stock
● Capital in Excess of par value
As long as the company has straightforward business experiences, equity capital remains a clear, straightforward set of accounts.
Assuming the company is making a net-profit and at least some of that is poured back into the business, then a new equity account is added and begins to grow with each year there is a final, positive net-profit:
● Retained earnings
Unfortunately, not everything goes according to plan in the business world. As the earlier article showed, depending on the financial situation of a company, other less clear equity accounts are added. Conceptually, making a profit is simple: sell for more than it costs. This doesn’t always happen in the real world and when it doesn’t, accountants still have to account for it. Here are some examples:
● Accumulated other comprehensive income/(loss)
● Employee benefit trust
● Treasury stock (aka Common Stock in treasury)
● Guaranteed ESOP Obligations
● Accumulated undistributed (overdistributed) net investment income (loss)
● Accumulated undistributed (overdistributed) net realized gain (loss)
● Net unrealized appreciation (depreciation) on:
- Investments
- Foreign currency translations
- Foreign capital gains tax
- Written options
What interesting, possibly mysterious, equity accounts have you come across?
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 71
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
Accessing Capital
July 8th, 2010
Copyright © 2010 Integrated Profitability TM
For any business, there are two ways to obtain capital:
● Borrow the money (e.g., loans)
● Sell ownership stakes (i.e., share in equity)
Loans are provided by entities that have capital they are looking to invest and who, when they look at your company, see, and believe in, a clear source of repayment. Early qualifiers for commercial lending are credit ratings and past history of a business’s ability to consistently generate profit.
Equity investments in a business are driven by investors who see, and believe in, the ultimate market success of a product or service and believe that the owners/management team have the skills, experience, and dedication to achieve that success.
In both cases, small businesses have distinct disadvantages:
● May lack a long history of profitable success
● Business model may only deliver small profits
● Creditworthiness may not yet be established
● Much larger competitors may exist in the same market
Bottomline is that these sources of capital may be scarce. If, therefore, your small business is funded by money from your savings or from friends and family, decide which type of capital it is. Ultimately it makes a difference to both sides:
With a positive outcome (e.g., successful profitability growth)
1. Loan
- means your business will pay the money back plus an agreed upon interest amount
- people who advanced the funds eventually receive principal and earnings
2. Equity
- means your business will give the investor a pro-rata share of any money taken out of the business (e.g., dividends, sale of the business)
With a negative outcome (e.g., goes out of business)
1. Loan
- the severity of the bankruptcy will determine how much, if any, of the original loan will be repaid. Usually, creditors receive some fraction of their money back.
2. Equity
- again, the severity of the bankruptcy will determine how much, if any, of the original investment will be received. Equity holders, however, receive no money until all creditors are paid. Thus, if creditors usually only receive a fraction of their loans back, equity investors will receive nothing.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 70
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
Capital Ratios: Safety Margins (6 of 6)
July 1st, 2010
Copyright © 2010 Integrated Profitability TM
As a reminder, Equity-Capital ratios that focus on a company’s safety margin are the main point of the Small Business Finance & Profitability Equity-Capital series:
● How large is your financial cushion?
● Are you well-capitalized?
Well-capitalized companies have flexibility that their less well-endowed competitors don’t:
● Funding for the business: more money can be poured into improving the business
There can be infrastructure investments to decrease costs and improve productivity. Research & Development (R&D) can be increased to develop better products and services. Process improvements can be made to increase customer satisfaction and loyalty. Marketing dollars can fine-tune new customer acquisition and new product development. Time and money can be spent on strategically thinking about, planning for, and taking action to maximize the company’s long-term, sustainable profitability.
● Weathering rough patches: money can be used to plug gaps in net-profit
As singer Lynn Anderson sang, “I never promised you a rose garden.” Business is never an unending string of profitable years. There are always a few potholes, and an occasional landmine, on the commercial highway, street, or back road. Equity-Capital allows companies to cover these rough spots without cannibalizing its operations.
● Rewarding investors: dollars can be returned to your investors
Healthy equity-capital allows companies to return some of their earnings to investors (either as dividends or as stock-share buybacks). Also, companies with solid equity accounts are better able to withstand downward pressure on their stock prices. Better investment returns to shareholders encourages a willingness among investors to purchase and hold a company’s stock. Access to the capital markets is an obvious advantage for a company.
Bottomline: in a rapidly changing global economy, strong equity-capital provides any company additional competitive advantages.
Capital, debt or equity, can’t replace solid management, good product/service lines, and efficient operations. Better-than-adequate equity-capital gives companies better odds at maintaining their leadership roles, especially when the inevitable stumbles come along.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 69
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
Capital Ratios: Safety Margins (5 of 6)
June 24th, 2010
Copyright © 2010 Integrated Profitability TM
The blog two weeks ago provided some basic ideas on quantifying the amount of equity-capital a business might want to harbor. Based on that simple model, two concepts fall out of the assumptions:
Break-even point: which is when adverse impacts cause revenue to exactly equal expenses. In other words, your net-profit is zero. You don’t make any money, but you don’t lose any either.
Based on the earlier assumptions, any of the following scenarios will cause you to break-even (ignoring the effect of income taxes):
● Revenue, alone, falls by $200,000
● Expense, alone, grows by $200,000
● Any combination of revenue change and expense change that nets to $200,000 less
Assuming you have living expenses, the second concept is Safety-point: which is the amount of net-profit necessary to live on. For example:
| Revenue | $1,000,000 |
| Expense (including income taxes) | 800,000 |
| Net-Profit | $200,000 |
| Minimum owner draw | 50,000 |
| Remainder for Investment, etc | $150,000 |
A simple definition of “Safety Point” is the point after which one’s “rainy day” account either gets broken into, or its funding is curtailed. Given these two definitions, difficulties facing your business will hit the “safety point” first. At that time, cash flow still exists but is definitely beginning to get squeezed.
If the difficulties continue to grow, the “Breakeven Point” is hit next, which means your cash flow is zero. At this point, your financial cushion will be used for the amount of “living expenses” you need. Hopefully your financial cushion is in cash—which means your cash balance will be decreasing. If the cushion is not in cash, see the next section.
Below the breakeven point, the difficulties will need to be met by either:
● Accessing debt (e.g., borrowing money)
● Running down equity-capital
Since this series is on equity-capital, let’s assume the crisis is not met with additional borrowing.
● From an accounting perspective, net-profit losses flow from the Income Statement to the Balance Sheet as “negative retained earnings”: that is, they reduce equity-capital.
● From a cash flow basis, net-profit losses are funded by reducing assets:
- First, cash and near-cash (e.g., financial investments)
- Then, the next most liquid assets that can be converted to cash (e.g., accounts receivable)
The most important facts at this point are: how valuable and liquid are your assets? If you have a strong Balance Sheet (i.e., current valuations and ready markets for the assets), then you will be able to use your assets to raise the funds needed to cover your net-profit losses.
If, however, your assets are over-valued or the markets for them have collapsed (sometimes these happen at the same time), then your equity-capital has collapsed as well.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 68
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
Integrated Profitability: Examples
June 17th, 2010
Copyright © 2010 Integrated Profitability TM
This week the companion blog, Integrated Profitability, is devoted to examples:
● a WHAT example (Tuesday; June 15, 2010)
● a WHEN example (Wednesday; June 16, 2010)
● a WHO example (Thursday; June 17, 2010) <today!>
● a WHY example (Friday; June 18, 2010)
Two weeks ago it was devoted to describing Integrated Profitability from a daily, ongoing basis:
● WHAT it is (Tuesday; June 1, 2010)
● WHEN to have it (Wednesday; June 2, 2010)
● WHO needs it (Thursday; June 3, 2010)
● WHY use it (Friday; June 4, 2010)
The concept of “Integrated Profitability” has been covered in an earlier blog.
If you’re interested, enjoy!
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 8-01-02
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
Capital Ratios: Safety Margins (4 of 6)
June 10th, 2010
Copyright © 2010 Integrated Profitability TM
In Capital Ratios: Safety Margins (3 of 6) published at the beginning of May, the types of risks that should be considered when figuring how much equity-capital is needed to support a company during rough times included:
a. How can you lose revenue?
b. How can your expenses increase?
c. How can your assets be impaired?
d. How can your liabilities increase?
Each of these high level drivers has many causes and each of those causes has some probability of happening. Assuming one has outlined the risks facing a business and assigned probabilities of such events happening (and with what severity, such as dollar amount and duration) within the next year, let’s look at a high-level model. For simplicity, the model below only touches on the Income Statement—although the Balance Sheet’s assets and liabilities can also cause problems.
Example of a Model
Assumptions ($ per annum):
● Profit dynamics
| Revenue | $1,000,000 |
| Expense (including income taxes) | 800,000 |
| Net-Profit | $200,000 |
● Revenue-at-Risk Range: -$50,000 (-5%) to -$500,000 (-50%)
● Expense-at-Risk Range: +$25,000 (+3%) to +$100,000 (+12%)
● Revenue Probability assessment: you feel the likelihood of losing half of your revenue is remote since it would involve losing your three largest clients at the same time. However, although you are doing everything possible to retain current customers, you feel there is a high probability of losing a net-$75,000 over the next year.
● Expense Probability assessment: after weighing the key expenses of your business (e.g., raw materials, personnel, marketing and sales to limit the potential decline in revenue), you feel that the highest probability of all-in expense growth is a $30,000 increase.
Under these assumptions, the business is probably going to take a $105,000 hit over the next year ($75,000 lower revenue and $30,000 higher expense). The profit dynamics assumed can absorb this: net-profit will decrease to $95,000 which can still be used to pay the owners or to reinvest in the business. So the first year can be weathered out of the current Income Statement.
How much equity-capital would you like to have? At least $105,000 would allow the company to tread water.
Next: Additional variables and examples of what impacts equity-capital considerations (scheduled for June 24, 2010)
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 67
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
Integrated Profitability: WHAT, WHEN, WHO, WHY
June 3rd, 2010
Copyright © 2010 Integrated Profitability TM
This week the companion blog, Integrated Profitability, is devoted to describing Integrated Profitability from a daily, ongoing basis:
● WHAT it is (Tuesday; June 1, 2010)
● WHEN to have it (Wednesday; June 2, 2010)
● WHO needs it (Thursday; June 3, 2010) <today!>
● WHY use it (Friday; June 4, 2010)
This four-part mini-series will be followed the week of June 14th with examples:
● a WHAT example (Tuesday; June 15, 2010)
● a WHEN example (Wednesday; June 16, 2010)
● a WHO example (Thursday; June 17, 2010)
● a WHY example (Friday; June 18, 2010)
The concept of “Integrated Profitability” has been covered in an earlier blog.
If you’re interested, enjoy!
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 8-01-01
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
What’s your profitability reporting?
May 27th, 2010
Copyright © 2010 Integrated Profitability TM
As a small business owner, what kind of profitability reporting do you use?
For example,
● How often do you review profitability reports?
● How many different profitability reports do you use?
● How are they prepared?
● Who prepares them?
● What sources feed the report(s)?
● What format or system are the reports in?
● Who receives them? Discusses them?
● Do the reports contain only financial information, or do they also have information regarding customers, products, inventory? Other important areas like marketing data?
At the end of the day, if the reports are helping you run your business, helping you avoid problems and letting you take advantage of opportunities, then your profitability reporting is doing its job. If, on the other hand, you always seem to be behind the curve, always being blind-sided, always having to run to catch up, then your profitability reporting is definitely in need of a make over.
● What’s worst about your reports?
● What’s best about your reports?
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 66
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
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