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
Capital Ratios: Safety Margins (3 of 6)
May 6th, 2010
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
Capital Ratios: Safety Margins (2 of 6)
April 29th, 2010
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
Capital Ratios: Operating/Liquidity
February 11th, 2010
Copyright © 2010 Integrated Profitability TM
Capital ratios that concentrate on operating/liquidity relationships are primarily focused on the immediate and short-term operation of the business. Operating ratios help owners track their ability to meet short-term obligations. These (balance sheet) ratios are complementary to the following, income statement, items:
● Cash flow
● Daily and/or ongoing liquidity
The purpose of these particular ratios is to monitor the company’s ability to keep the business afloat in the short-run. Depending on how fast cash is being spent and received, operating ratios can also help forecast how long before running into operating (solvency) problems.
The major operating ratios are*1:
1. Current Ratio
Current ratio = current assets / current liabilities
Measures whether current liabilities will be paid from current assets. A ratio of 1.0 is breakeven; higher is better.
2. Quick Ratio (Acid Test)
Quick Ratio = (current assets – inventory) / current liabilities
Measures whether the most liquid assets will be sufficient to pay current liabilities
(Note:
Current assets include cash, marketable securities, accounts receivables and inventory
Current liabilities include accounts payable, short-term notes payable, current maturities of long-term debt, and accrued expenses & income taxes)
Here is a useful website:
If your business is small enough, you probably carry these ratios around in your head. And deal with them every day. Still, when all goes well and your business grows, you will have much more important things to work on. Regularly reported operating ratios will be an ongoing connection to how well your expanding business is doing in this critical area.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 53
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
*1: Eugene F. Brigham, Fundamentals of Financial Management (Illinois: Dryden Press, 1978) p. 125.
Capital Ratios: Overview
January 28th, 2010
Copyright © 2010 Integrated Profitability TM
Capital is fundamentally critical to a company. Not only does it provide the initial funds to launch your business, it is also the financial resource that helps to:
● Fund growth when times are good
● Cover losses when times are bad
In a sense, it doesn’t matter whether your business is doing well or poorly: capital is there to help you thrive or survive.
Given its importance, the amount of capital a company has is part of several ratios to monitor the health of the business. Capital, and its relationship to other aspects of your profit dynamics, is an important performance measurement.
Here are some useful sites:
● Accounting Ratios for Financial Statement Analysis
http://www.cpaclass.com/fsa/ratio-01a.htm
● Answers.com (Capital Ratio)
http://www.answers.com/topic/capital-ratio
● Wikipedia: Capital Requirement
http://en.wikipedia.org/wiki/Capital_requirement
● FDIC (Federal Deposit Insurance Corporation)
http://www.fdic.gov/bank/analytical/fyi/2003/011403fyi.html
Over the years, several capital ratios have been developed to monitor different aspects of a business. These ratios might be categorized as follows:
● Operating Margins
Margins that focus on the ongoing health of the business and how efficiently capital, from whatever source, is being used
● Regulatory Margins
Margins that are dictated by governmental agencies. Companies subject to such requirements must ensure that they run their businesses, including the amount of capital, in such a way that they meet or exceed these mandates.
● Safety Margin
Margins that focus on ensuring there is sufficient financial cushion in the company to withstand anticipated adverse impacts related to the business the company is in
In the coming weeks, we will look at all three.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 51
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
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