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
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