Capital Ratios: Safety Margins (2 of 6)
April 29, 2010, 5:00 am
Copyright © 2010 Integrated Profitability TM
I’ve argued that one of the purposes of Equity-capital is to allow companies to weather the inevitable set-backs suffered by anyone in business. When these problems happen, it doesn’t matter whose fault it is. That needs to be figured out and eventually dealt with. But the first priority is dealing with the problem itself and minimizing its harmful effects.
What are these “rough spots”?
The good news is that there are only a few sources. The bad news is that there is an unending supply of causes. The sources:
● From the Income Statement
- Revenue losses
- Expense increases
● From the Balance Sheet
- Asset impairment
- Liability growth
When any of these four events happen, your business has hit a rough spot. The size and shape of the pot hole you’ve just driven into is determined by that infinite number of causes. Here are a few examples:
● Revenue losses
In general, any revenue loss is a problem (see caveat below). A company can lose revenue for any number of reasons: competitors’ actions, problem with your product or supply, economic downtown, fundamental market change (e.g., VHS won, Betamax lost).
● Expense increases
In general, expense increases are problems. Granted, some expense increases are necessary for long-term success, like investment in new products. With your ongoing core business, however, increases in supplier products and services dent your net-profit. Large spikes (e.g., produce prices soar because of a bad frost) or large, steady increases (e.g., recently, university or health care costs) in expenses are the biggest problems.
● A combined Revenue/Expense caveat:
If a revenue loss is in a product whose price is less than the marginal cost, then there will be a positive impact on net-profit.
● Asset impairment
On the Balance Sheet, the term or life of the asset is important. If the value of your building decreases, that is probably not an issue until you sell it. If one of your customers goes bankrupt and you are holding 30-day Account Receivables from them: that is an immediate problem.
● Liability growth
As with assets, the term of the liability is important. If you delay payment on your Account Payables, your liability will increase by the amount of additional interest and fees. It’s hard to imagine other liabilities growing. However, unanticipated legal actions (e.g., law suits) can suddenly add to liabilities.
Next Week: How to model the risk to your business (scheduled for May 6, 2010)
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 62
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
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