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
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