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
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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