Capital Ratios: Safety Margins (4 of 6)
June 10, 2010, 12:01 am
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
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