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
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
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 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: Its Purposes & Sources
December 10th, 2009
Copyright © 2009 Integrated Profitability TM
Capital has two main purposes:
● an initial one and
● an ongoing one
Initially, capital is the seed-money to finance the launch of a new business. New ventures begin with nothing and need funding. This capital can come from any source, such as personal savings, private investors, venture capitalists or the proceeds of the issuance of shares of stock. Each source will demand some sort of compensation for advancing funds. The most common is an equity stake in the new company.
For corporations, ownership is denominated in terms of a specified number of shares. Each of these shares is given a par value, usually $1.00. These shares are them offered to financial markets for purchase and investors bid on them based on their estimates of the overall value of the business concept embodied in the company. Investors pay for the shares with cash that is the seed money for the new venture.
This initial infusion of cash (the balancing entry to the capital invested) allows the new business to fund its activities, bring its products & services to market, and start attracting customers, sales and the beginning of an ongoing business. As “Capital Structures: Market Examples & Other Names for Capital” showed, this capital consists of Common/Preferred Stock (at par value) and Capital in Excess of par value.
Assuming the new business is successful, any annual positive profit that is poured back into the company is booked into the “Retained Earnings” account in the capital section of the Balance Sheet. As long as the business is growing, is consistently profitable, and
profit is re-invested in the business, then the “Retained Earnings” account will continue to increase.
At this point, when the company is an ongoing commercial venture, the purpose of capital is to act as a buffer to absorb any downturn in the business. Risks are inherent in all business activities. It is important to identify them and then gauge the probability of their adversely impacting the company.
If the company suffers difficulties large enough to cause a loss in the Income Statement, then accumulated “Retained Earnings” are used to absorb that loss. Therefore, the more capital a company has, the larger a loss it can handle. Likewise, if the market hits a longer term business downturn, larger capital accounts allow companies to weather losses for a longer time.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 46
Telephone: 925-202-6244
Copyright © 2009 Integrated Profitability TM
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