Equity Capital: Intriguing Weirdnesses
July 15th, 2010
Copyright © 2010 Integrated Profitability TM
Near the beginning of this series on equity- capital, Equity Structures: Market Examples & Other Names for Equity went over the basic components of a company’s equity structure. In the beginning of a company’s life, the equity part of the balance sheet is straightforward:
● Preferred Stock (if issued)
● Common Stock
● Capital in Excess of par value
As long as the company has straightforward business experiences, equity capital remains a clear, straightforward set of accounts.
Assuming the company is making a net-profit and at least some of that is poured back into the business, then a new equity account is added and begins to grow with each year there is a final, positive net-profit:
● Retained earnings
Unfortunately, not everything goes according to plan in the business world. As the earlier article showed, depending on the financial situation of a company, other less clear equity accounts are added. Conceptually, making a profit is simple: sell for more than it costs. This doesn’t always happen in the real world and when it doesn’t, accountants still have to account for it. Here are some examples:
● Accumulated other comprehensive income/(loss)
● Employee benefit trust
● Treasury stock (aka Common Stock in treasury)
● Guaranteed ESOP Obligations
● Accumulated undistributed (overdistributed) net investment income (loss)
● Accumulated undistributed (overdistributed) net realized gain (loss)
● Net unrealized appreciation (depreciation) on:
- Investments
- Foreign currency translations
- Foreign capital gains tax
- Written options
What interesting, possibly mysterious, equity accounts have you come across?
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 71
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
Accessing Capital
July 8th, 2010
Copyright © 2010 Integrated Profitability TM
For any business, there are two ways to obtain capital:
● Borrow the money (e.g., loans)
● Sell ownership stakes (i.e., share in equity)
Loans are provided by entities that have capital they are looking to invest and who, when they look at your company, see, and believe in, a clear source of repayment. Early qualifiers for commercial lending are credit ratings and past history of a business’s ability to consistently generate profit.
Equity investments in a business are driven by investors who see, and believe in, the ultimate market success of a product or service and believe that the owners/management team have the skills, experience, and dedication to achieve that success.
In both cases, small businesses have distinct disadvantages:
● May lack a long history of profitable success
● Business model may only deliver small profits
● Creditworthiness may not yet be established
● Much larger competitors may exist in the same market
Bottomline is that these sources of capital may be scarce. If, therefore, your small business is funded by money from your savings or from friends and family, decide which type of capital it is. Ultimately it makes a difference to both sides:
With a positive outcome (e.g., successful profitability growth)
1. Loan
- means your business will pay the money back plus an agreed upon interest amount
- people who advanced the funds eventually receive principal and earnings
2. Equity
- means your business will give the investor a pro-rata share of any money taken out of the business (e.g., dividends, sale of the business)
With a negative outcome (e.g., goes out of business)
1. Loan
- the severity of the bankruptcy will determine how much, if any, of the original loan will be repaid. Usually, creditors receive some fraction of their money back.
2. Equity
- again, the severity of the bankruptcy will determine how much, if any, of the original investment will be received. Equity holders, however, receive no money until all creditors are paid. Thus, if creditors usually only receive a fraction of their loans back, equity investors will receive nothing.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 70
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
Integrated Profitability: Examples
June 17th, 2010
Copyright © 2010 Integrated Profitability TM
This week the companion blog, Integrated Profitability, is devoted to examples:
● a WHAT example (Tuesday; June 15, 2010)
● a WHEN example (Wednesday; June 16, 2010)
● a WHO example (Thursday; June 17, 2010) <today!>
● a WHY example (Friday; June 18, 2010)
Two weeks ago it was devoted to describing Integrated Profitability from a daily, ongoing basis:
● WHAT it is (Tuesday; June 1, 2010)
● WHEN to have it (Wednesday; June 2, 2010)
● WHO needs it (Thursday; June 3, 2010)
● WHY use it (Friday; June 4, 2010)
The concept of “Integrated Profitability” has been covered in an earlier blog.
If you’re interested, enjoy!
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 8-01-02
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
Integrated Profitability: WHAT, WHEN, WHO, WHY
June 3rd, 2010
Copyright © 2010 Integrated Profitability TM
This week the companion blog, Integrated Profitability, is devoted to describing Integrated Profitability from a daily, ongoing basis:
● WHAT it is (Tuesday; June 1, 2010)
● WHEN to have it (Wednesday; June 2, 2010)
● WHO needs it (Thursday; June 3, 2010) <today!>
● WHY use it (Friday; June 4, 2010)
This four-part mini-series will be followed the week of June 14th with examples:
● a WHAT example (Tuesday; June 15, 2010)
● a WHEN example (Wednesday; June 16, 2010)
● a WHO example (Thursday; June 17, 2010)
● a WHY example (Friday; June 18, 2010)
The concept of “Integrated Profitability” has been covered in an earlier blog.
If you’re interested, enjoy!
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 8-01-01
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
What’s your profitability reporting?
May 27th, 2010
Copyright © 2010 Integrated Profitability TM
As a small business owner, what kind of profitability reporting do you use?
For example,
● How often do you review profitability reports?
● How many different profitability reports do you use?
● How are they prepared?
● Who prepares them?
● What sources feed the report(s)?
● What format or system are the reports in?
● Who receives them? Discusses them?
● Do the reports contain only financial information, or do they also have information regarding customers, products, inventory? Other important areas like marketing data?
At the end of the day, if the reports are helping you run your business, helping you avoid problems and letting you take advantage of opportunities, then your profitability reporting is doing its job. If, on the other hand, you always seem to be behind the curve, always being blind-sided, always having to run to catch up, then your profitability reporting is definitely in need of a make over.
● What’s worst about your reports?
● What’s best about your reports?
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 66
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
What to: Do, Delegate, Outsource
May 20th, 2010
Copyright © 2010 Integrated Profitability TM
The owner/manager of a small business only has so much time in a day to do everything that is needed for the company to survive and, hopefully, thrive.
As hinted at last week, nobody can do everything. To paraphrase Abraham Lincoln:
● You can do everything some of the time
● You can do some things all the time
● But you can’t do everything all the time
Owner/managers who try to do everything all the time eventually:
● Burn themselves out
● Do everything less well than possible or even desirable
● Restrict the growth of the company to their own, self-imposed, time and quality constraints
Owner/managers need to put all the activities required * to run their companies into three categories:
1. Do
These are strategic activities; the ones that suit your knowledge, skill, and experience. Allows you to keep focus on the big picture, to keep your finger on the health of the business.
2. Delegate
These are more tactical; frequently those that are process related or procedural in nature. They can also be those activities that require knowledge, skill, and experience that you don’t have in sufficient quantity or quality: activities that others do better than you.
3. Outsource
These tasks have similar characteristics to those that you delegate, with the added feature that an outside company has built their business model on performing exactly those activities and they can do them more effectively and cost-efficiently than you or your staff, at the same or better quality and same or less risk.
The more efficiently and effectively work is done, the better opportunity for growing profitability.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 65
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
Footnote:
*: There is a fourth category: activities that DON’T need to be done. These can be hard to spot. Basically, though, if regulations don’t require an activity, it doesn’t do anything for profitability, and/or it isn’t something you should morally be doing; then it’s probably not necessary.
Defining Management
May 13th, 2010
Copyright © 2010 Integrated Profitability TM
For small businesses, what’s a good definition of management? Or, put another way, what are the most important attributes of an owner who is the management of a small business?
● Knowing the business
This runs the gamut from what’s the product/service, how it’s produced & delivered, who’s the clientele, how is profit generated (one’s profit dynamics), and what is the market doing
● Vision
Knowing where and what the business is today; AND where it is going. As long as the business is successful, “where it is going” is never really reached. It gets bigger and better as the market continually changes, but it always is in the future. As soon as one milestone is reached, there should always be further ones on the horizon.
● Delegation
As John Donne said:
“No man is an island, entire of itself,…”
Likewise, no single person can run everything about a business—especially one that is growing. An essential characteristic of management is knowing WHAT to delegate and then to delegate that to the best people.
● Keeping track
A good manager delegates responsibilities to others. At the same time, that manager needs to keep track of everything that is going on—well, not everything since that would be way too much detail.
A reporting mechanism that continually feeds the most critical information on the health of the business, however, is needed. This means identifying and reporting “key indicators” that drive the success, or failure, of the business.
Like a spider, management must have a superbly sensitive web of information to know everything of importance that is going on. The earlier one knows of something, whether good or bad, the more time there is to act. The first and second characteristics, knowledge and vision, should be sufficient to allow such a reporting network to be created.
● Managing
Personally, I prefer the word “leading” but both are necessary to ensure that the wheels of the business are in fact working well. An integral part of management is ensuring that responsibility and accountability are embraced by everyone who works for, or with, the company.
What have I missed?
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 64
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
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