Capital Ratios: Safety Margins (6 of 6)
July 1st, 2010
Copyright © 2010 Integrated Profitability TM
As a reminder, Equity-Capital ratios that focus on a company’s safety margin are the main point of the Small Business Finance & Profitability Equity-Capital series:
● How large is your financial cushion?
● Are you well-capitalized?
Well-capitalized companies have flexibility that their less well-endowed competitors don’t:
● Funding for the business: more money can be poured into improving the business
There can be infrastructure investments to decrease costs and improve productivity. Research & Development (R&D) can be increased to develop better products and services. Process improvements can be made to increase customer satisfaction and loyalty. Marketing dollars can fine-tune new customer acquisition and new product development. Time and money can be spent on strategically thinking about, planning for, and taking action to maximize the company’s long-term, sustainable profitability.
● Weathering rough patches: money can be used to plug gaps in net-profit
As singer Lynn Anderson sang, “I never promised you a rose garden.” Business is never an unending string of profitable years. There are always a few potholes, and an occasional landmine, on the commercial highway, street, or back road. Equity-Capital allows companies to cover these rough spots without cannibalizing its operations.
● Rewarding investors: dollars can be returned to your investors
Healthy equity-capital allows companies to return some of their earnings to investors (either as dividends or as stock-share buybacks). Also, companies with solid equity accounts are better able to withstand downward pressure on their stock prices. Better investment returns to shareholders encourages a willingness among investors to purchase and hold a company’s stock. Access to the capital markets is an obvious advantage for a company.
Bottomline: in a rapidly changing global economy, strong equity-capital provides any company additional competitive advantages.
Capital, debt or equity, can’t replace solid management, good product/service lines, and efficient operations. Better-than-adequate equity-capital gives companies better odds at maintaining their leadership roles, especially when the inevitable stumbles come along.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 69
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
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
Captial Ratios: Safety Margins (1 of 6)
March 11th, 2010
Copyright © 2010 Integrated Profitability TM
Equity-Capital ratios that focus on a company’s safety margin are the main point of the Small Business Finance & Profitability Equity-Capital series:
● How large is your financial cushion?
● Are you well-capitalized?
Here are two major “safety margins” that are widely used:
Debt / Shareholder Equity
Purpose: to assess how leveraged your company is and, more specifically since debt is paid off first, how much cash is available to cover financial challenges (in the worst case, this ratio indicates how much value would be left for shareholders/owners if the company had to be liquidated)
2. Working Capital Ratio (Current Ratio)
Current Assets / Current Liabilities
Purpose: to know how well your current assets (e.g., cash) cover your current liabilities (e.g., short-term accounts payable)
CPAclass.com is a helpful website with a good list of main financial ratios.
These two ratios are useful in assessing the financial health of a company, particularly the ability to pay bills and debt. However, they are calculated from items on the Balance Sheet, not from the dynamism of the Income Statement which is where many, if not most, financial difficulties come from for small businesses.
To reiterate the benefits and uses of equity-capital:
● Funding for the business: more money can be poured into improving the company
● Weathering rough patches: money can be used to plug gaps in net-profit
● Rewarding investors: dollars can be returned to your investors
Subsequent installments of this article delve more deeply into ways to identify and quantify those rough spots—and gauge how adequate your equity-capital is to survive them. Something along the lines of whether or not you have enough tarmac to fill in the pot-holes your business might be hitting.
The next article is scheduled for April 29, 2010: during the week devoted to “Risk.”
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 57
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
Capital Ratios: Regulatory
March 4th, 2010
Copyright © 2010 Integrated Profitability TM
For some companies, there are special ratios related to capital. Government regulators specify certain minimum levels of capital for corporations in particular industries. The regulators are also very specific as to what may be included when calculating these ratios. The most visible industry is financial institutions where regulators require a certain amount of capital be maintained at all times to protect customers (e.g., consumers depositing their savings in a bank).
The intent is to ensure that there is always a certain level of capital to protect against financial difficulties. These ratios are a kind of forced financial prudence. The main one for financial institutions is the “Capital Adequacy Ratio” (CAR). It’s calculated generically as follows:
Certain types of Capital / Risk-weighted Assets
Both the numerator and the denominator use specific categories of capital and assets respectively because neither is created equal. Assets can become impaired in completely different ways, under different circumstances, and with completely different speeds. Therefore, assets are weighted by the amount of risk they bear. These assessments quickly become complicated. Suffice to say, the capital ratios are specified with the intent of maximizing the ability of the bank to stay in business.
Here are a few pertinent websites:
● Bank for International Settlements and the Basle Committee
● Article on Capital Ratios from the Motley Fool
● Capital Ratio from Answers.com
At the end of the day, regulatory ratios are just another requirement of doing business. If you are in a regulated industry with mandated capital ratios, this is one more environmental aspect you must meet. It is the same as any business that sells a product or service subject to sales (and other) taxes: you must be aware of them and you must abide by them.
If you don’t, your resources will be commandeered to deal with the non-compliance. Your time and effort will be directed toward responding to regulators, defending your position (if you have one), and rectifying the issue to the satisfaction of the regulators.
Bottomline: You may think capital ratio requirements are onerous, but they have been put into law for solid economic reasons. The driving force may not be to specifically protect you (the owner), but if the margins give you a bigger financial cushion, thereby making your business safer, then they do, in fact, help you.
If you are in a business that requires regulatory margins, know what they are and make sure your business model and profit dynamics include them.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 56
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
Capital vs. Equity
January 21st, 2010
Copyright © 2009 Integrated Profitability TM
When I started the “Capital” series back in October 2009, I should have taken that critical first step: set definitions.
In the eagerness to get started on something new, and especially on those projects that are really necessary or important, beginnings sometimes get rushed and that can cause rockiness down the way. For example, the series really isn’t about capital, it’s apart a specific portion of capital: the equity, shareholder/owner portion of capital. The series will be re-named “Equity-Capital.”
So, starting at the beginning as we near the end:
Capital Structure:
The percentage of each type of capital used by the firm—debt, preferred stock, and net worth (net worth consists of capital, paid-in capital, and retained earnings).*1
Equity:
The net worth of a business, consisting of capital stock, capital (or paid-in) surplus, earned surplus (or retained earnings), and, occasionally, certain net worth reserves. Common equity is that part of the total net worth belonging to the common stockholders. Total equity would include preferred stockholders. The terms common stock, net worth, and common equity are frequently used interchangeably.*2
Everything perfectly clear now? While doing research for this blog, I came across a passage in a text book under a sub-title of “Definitions of Capital” which I was quite happy to see:
“When accountants refer to capital they mean stockholders’ equity or owners’ equity.”*3
I couldn’t have said it better myself!
Anyway, remember the earlier series on “Numbers People”?
This definitional issue is a perfect example as to why accountants are so critical to the success of a business. They define the transactions, set the standards, and oversee the infrastructure in which the financial booking takes place.
And they keep those finance people in place. Sooner or later.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 50
Telephone: 925-202-6244
Copyright © 2009 Integrated Profitability TM
*1: Eugene F. Brigham, Fundamentals of Financial Management (Illinois: Dryden Press, 1978) p. 568.
*2: Brigham p. 571.
*3: Donald E. Kieso and Jerry J. Weygandt, Intermediate Accounting Second Edition (Santa Barbara: Wiley/Hamilton Publication 1977) p. 602.
Capital Series: Mea Culpa
January 14th, 2010
Copyright © 2010 Integrated Profitability TM
On October 26, 2009 I started this series on “capital” and to date six posts have been made. And every one of them has in intrinsic definitional flaw:
“Capital” includes all sources of funds that may be accessed by a company
I have written each article to focus exclusively on the “owners’” portion of capital. Here’s the issue in a nutshell:
● Capital includes all sources of funds
● Capital includes loans as well as owner investments
● Loans are liabilities
● Capital includes both liabilities (loans) and equity (stock investments)
Unfortunately, in the six posts to date I did not make my focus explicit and, worse, I mis-used the word “capital.” A much better word, given the focus of this series, is “Equity” which is the owners’ investment, or stake, in the company.
I apologize for the mistake. And, make no mistake, it is a mistake. I will go back to every “Capital” post-to-date and make the wording accurate.
If every storm cloud has a silver lining, this episode confirms the importance of several characteristics “Integrated Profitability” strives for:
● Accuracy
● Trust, Honesty, Integrity
● Full Disclosure
● Responsibility
● Accountability
I sincerely apologize for this mistake.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 49
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
Equity: Accounting for the Stuff
January 7th, 2010
Copyright © 2010 Integrated Profitability TM
Accountants are indispensable for setting up and maintaining the financial records of your business. They are never more valuable than when accounting for the capital in your business.
Earlier, we covered the two main sources and uses of capital. Here is a high-level overview of how one accounts for the two main sources of capital:
1. Initial Investment
Event:
● Issue 100,000 shares of stock at $1.00 each
● Investors buy the 100,000 shares for an average, net-price of $17.83 per share
● All investors pay for their shares in cash
Balance Sheet
Asset Liabilities
Cash $1,783,000 Liabilities $ 0
Capital
Par Value $ 100,000
Excess over Par $1,683,000
Total: $1,783,000 Total: $1,783,000
2. Retained Earnings
Good news! The first year of business was excellent and your business made money. Being the first year, no dividends were paid and you poured net profit, after tax, back into the business.
Income Statement
Revenue $1,000,000
Expenses $ 875,000
Pre-tax Net Income $ 125,000
Tax $ 43,750
Net-Profit $ 81,250
Since this is a high-level overview, all the in-&-outs of all the activity of the business are not included: for example, cash from the initial stock offering was used to pay the expenses to generate the revenue; as well as buying a few assets necessary to the running of the business.
So, focusing on the capital accounts:
Balance Sheet
Asset Liabilities
Cash $ 112,000 Liabilities $ 0
Capital
Equip $ 552,000 Par Value $ 100,000
Other $1,200,250 Excess over Par $1,683,000
Retained Earnings $ 81,250
Total: $1, 864,250 Total: $1,864,250
That’s the accounting in a nutshell. The migration of “Net Profit” from the Income Statement to the capital account on the Balance Sheet is one of the most intricate accounting processes.
But it is, for owners, the bottom line.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 48
Telephone: 925-202-6244
Copyright © 2009 Integrated Profitability TM
Equity: Its Uses & Sufficiency
December 22nd, 2009
Copyright © 2009 Integrated Profitability TM
A previous article, “Capital: Its Purposes & Sources” covered:
| Purpose | Uses |
| Initial seed money for new ventures | Purchasing assets, paying for operations & processes, acquiring customers |
| Ongoing buffer for adverse impacts | Covering losses in the ongoing business |
Initial infusion of Capital: used for setting up the company, acquiring office or factory space, hiring personnel, obtaining contracts and service agreements with companies who will provide manufacturing, services or risk protection (e.g., insurance), buying equipment, furniture and other assets.
Ongoing buffer for business: used for adverse market, business or self-inflicted problems that are large enough to cause a loss, i.e., net-profit becomes negative. There is an unending list of such adverse impacts. Here are a few market-based ones:
● You lose your largest customer and can’t reduce expenses fast enough to offset the loss of revenue
● A competitor brings a materially better product to market and buries you
● Your manufacturing process produces a major flaw and you are required to do a massive recall
● Your key supplier goes bankrupt and it costs significantly more to replace the goods
● The national and world economies fall into recession and demand for your product or service dries up
The Antioch Unified School District is in the midst of adverse conditions right now.
When any of these events cause your net-profit to go negative, the amount of retained earnings accumulated during earlier, more profitable years are used to cover the losses.
Given these purposes and uses, how much capital is sufficient for any given company? Calculating this amount depends on the profit dynamics of each business and the market it is in. Some businesses have fairly steady profit profiles (e.g., grocery stores), while others have wildly erratic ones (e.g., investment banking).
Irrespective of the business’ profitability profile, the first step is understanding, estimating and quantifying the types of risk facing your company. With these scenarios and estimates in hand, the following questions need to be asked:
1. what is the largest loss possible if all the risks converged at the same time on the company?
2. how long would the risks adversely impact the business of the company?
Based on intimate experience with your company’s business and its market, probabilities may be applied to different scenarios involving the various risks.
The amount of capital needed for a particular business should be the amount needed to stay in business for at least one year; two years is a much more prudent goal. With this amount of capital available, the company will have two years to deal with whatever business challenges it is facing.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 47
Telephone: 925-202-6244
Copyright © 2009 Integrated Profitability TM
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