Capital Ratios: Safety Margins (3 of 6)
May 6, 2010, 5:00 am
Copyright © 2010 Integrated Profitability TM
Your business is subject to various risks. To determine whether or not you have enough equity-capital to withstand those risks, you first need to model their impact.
Here are some steps:
1. Identify the risks inherent in your business
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?
In other words, what has to happen for your business to get hurt by any of the four events above? Be specific.
2. For each identified risk-event, what is the range of dollar impact to your business?
For example, if you lost your largest customer, how much revenue would you lose (offset, perhaps, by expense decreases)? If some event happened (e.g., a strike, plant closure, bridge collapse, discovery of a massive killer-bee hive), what sales and revenue would you lose? For how long?
3. a. What are the probabilities of these individual events happening, with a range of severity (which includes both number of events and length of time)?
b. What are the probabilities of these different events happening at the same time or in conjunction with each other?
4. By combining #2 (dollar amounts) and #3 (probability of happening), you can calculate a range of potential “rough spots” from “small & highly likely” to “huge & highly unlikely.”
It’s desirable that your business have a continuum of risk-impact with the following correlation:
As dollar size increases, probability decreases.
The purpose of equity-capital is to identify how far along that continuum the risks in your business will take you. At what point will you be safe? One convenient way to gauge this is to estimate the dollar size of the adverse impacts that would put you out of business in one-year.
That is, what level of losses could hit your business over the course of one year? The hope is that within one year, whatever is causing the problem(s) will have been solved.
That number is the minimum amount of equity-capital you need.
Next: Example of how to model risk to a business (scheduled for June 10, 2010)
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 63
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
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