ii / Business Management Daily
Authors: NeilGriffin,DonBattle,RaymondJ.Lipay Editor: KathyA.Shipp Editorial Director: PatrickDiDomenico Associate Publisher: AdamGoldstein Publisher: PhillipA.Ash
©2011,2005,1996,BusinessManagementDaily,adivisionofCapitolInformationGroup,Inc.,7600ALeesburgPike,WestBuilding, Suite 300, FallsChurch,VA22043-2004;www.BusinessManagementDaily.com;phone: (800)543-2055.Allrightsreserved.Nopartofthisreportmaybereproducedinanyformorbyanymeanswithoutwrittenpermissionfromthepublisher.PrintedinU.S.A.
ISBN:1-880024-09-8
“Thispublicationisdesignedtoprovideaccurateandauthoritativeinformationinregardtothesubjectmattercovered.It issoldwiththeunderstandingthatthepublisherisnotengagedinrenderinglegal,accountingorotherprofessionalservice.Iflegaladviceorotherexpertassistanceisrequired,theservicesofacompetentprofes-sionalpersonshouldbesought.”—From a Declaration of Principles jointly adopted by a committee of the American Bar Association and a committee of publishers and associations.
Mastering Business Finance / iii
ContentsWhat Every Manager Should Know 1 Are You Savvy About Finance? 2
1. Learning the Tools of the Trade 3 The Balance Sheet 3 Sample Corporate Balance Sheet 4 Assets 5 Liabilities and Equity 5 The Income Statement 5 Sample Income Statement 6 The Statement of Cash Flows 7 Sample Statement of Cash Flows 8
2. How the Financial Pros Use These Tools 10 Troubleshooting With Ratio Analysis 10 Ten Critical Ratios 10 Does your firm have enough cash to pay its bills? 12 To leverage or not to leverage? 12 How profitable is your firm? 12 Should you provide credit to a customer? 12
3. AnsweringSomeDifficultFinancialQuestions 14 AQuestionofProfitMargins 14 A Question of Working Capital 15 RMA’s Annual Statement Studies 15 A Question of Returns 16 A Question of Asset Management 17 A Question of Debt Strategy 18 A Question of Purchasing 19 A Question of Stability 20
4. ProfitFromYourBudget 22 The Budgeting Process 22 Developing a Budget System That’s Right for You 22 Organizing a Budget Team 23 The Budget Committee 24 The Budget Chairman 24 Team Budgeting 24 A Look at Zero-Base Budgeting 25 What Not to Expect From a Budget 27
5. ShouldYouUseaFixedorVariableBudget? 29 Limitations of a Fixed Budget 29 How Rising Sales Can Affect a Fixed Budget 29 How Falling Sales Can Affect a Fixed Budget 30 Comparing Changes 30
iv / Business Management Daily
Using a Variable Budget 30 The Need for Flexibility 30 Budgeting After the Fact 31 Getting What You Pay For 31
6. ProducinganEffectiveBudget,StepbyStep 32 Step 1: Develop a Sales Forecast 32 Step 2: Develop Measures of Activity 33 Step 3: Collect Historical Data 34 Step 4: Do Cost Analysis 34 Step 5: Determine Budget Allowances 35 Expense Budget, Year Ending Dec. 31: ABC Corporation 36 Step 6: Review Expense Budgets 37 Step7:EstimateProfits 37 Using Your Budget 38 Remember to Follow Up 38 Revising Your Budget 38
7. ManagingYourCash 40 Making Cash-Flow Decisions 40 Using Your Cash Budget 41 Where to Obtain the Right Cash-Flow Information 42 Expense Budget: ABC Publishing Company 42 Cash Budget: ABC Publishing Company 43 Receipts and Disbursements Analysis 43 Receipts and Disbursements Analysis: ABC Publishing Company 45 Flow of Funds Analysis 45 Flow of Funds Analysis: ABC Publishing Company 46 Forecasting Your Cash Flow 47 Preparing a Short-Term Cash-Flow Forecast 48 Role of Cash-Flow Assumptions 48 Using a Long-Term Cash-Flow Forecast 49 Adapt Flow-of-Funds Analysis 49 Long-Term Cash Forecast: ABC Publishing Company 50 Keeping Cash Flow Under Control 51 The Cash-Flow Statement 51 Liquidity Report 51 Flow-of-Funds Statement 52 Making Your Cash Count 53 Managing a Financial Emergency 53 Priority List 54
8. CapitalInvestmentBasics 56 How to Prepare a Capital Investment Proposal 56 Classifying Capital Spending Projects 56 Avoiding Common Pitfalls 57 Calculating Your True Capital Costs 58 Assessing the Cost of Debt 58 What Are Equity Costs? 58
Mastering Business Finance / v
Ways to Measure Your Expected Return 59 The Payback Method 59 Using Net Present Value to Measure Return 61 Understanding the Discounting Concept 61 Discounting to Find NPV 62 Table 1: Present Value Factors 63 Using Internal Rate of Return 63 Calculating Internal Rate of Return (IRR) 64 The Hurdle Point: Uses and Misuses 65 Determining Flexible Hurdle Rates 65 Analyzing Your Capital Investment Risks 66 Weighted-Risk Analysis 67 Adjusting for Probabilities 67 Alternate Scenarios Measure Risk 68 Probability Adjustment—ABC Company 68
9. HowtoRaiseMoney 69 Keep a Business Plan on Hand 69 Contents of a Business Plan 69 When a Shorter Proposal Will Do 70 Where to Look for Funds 71 Internal Financing 71 Customers Come First 71 Make Your Employees Owners 72 The ABCs of Bank Borrowing 72 Finding the Right Type of Loan 73 Score Your Loan Worthiness 75 The Loan Application 75 If Your Banker Turns You Down... 77 Loan Guarantees From the SBA 77 How PLP Works 78 Loans From Commercial Finance Companies 78 Using a Factor 79 Bond Financing 80 Raising Equity Capital 81 How to Attract a Venture Capitalist 81 Evaluating a Venture Capitalist 82 Dealing With an SBIC 82 The Role of the Private Investor 83 Regulation D Private Placement 84 Raising Capital Through a Public Stock Offering 85 Other Methods of Financing 86 A Look at Leasing 86 Don’t Forget Development Corporations 87
Glossary 88
1
What Every Manager Should Know
Nosubjectseemstopervadeourlivesasmuchasfinance.Whetherit’swres- tlingwithyourfamilybudgetorseeingifyourcompanyqualifiesfora bankloan,financeloomslargerthananyothertechnicalsubjectonadaily
basis.Withdownsizingofcompaniesandstaffs,managersateverylevelarehav-ingtofacefinancialmattersinever-greaterproportionstoday.Ifyouhaven’tyetbeenaskedtoscaledowninventoriesorsetupfinancingfordepartmentalprojects,chancesareyouwillbesoon.
Intoday’scorporateenvironment,nonfinancialmanagersareexpectedtomakefinancialdecisionsfast.Infact,yourdecisionoftenwasdue“yesterday.”Ifthat’snotenoughpressure,thearrivalofcomputersandcyberspacehasgivenyourcompeti-tionaccesstomorefinancialfacts,ingreaterdetailandmorepromptly,thaneverbefore.Theneedtomakefinancialdecisionsquicklyisvitaltoyoursuccess.There’snotimeforanin-depthstudyoffinancialconceptsandtheirmeaningwhenyourbossoryouremployeesareexpectingayesornoanswerrightaway.
Thisreportismeanttostripawaythefearandconfusionyoumayexperienceaboutfinance.Itexplainsexpenseandcapitalbudgets,financialanalysisandcashmanagement,andtellsyouhowtogoaboutraisingmoney—allinlanguagethat’seasytounderstand.Weexplain jargonwherewehavetouseit—andwherewethinkthatapicturewouldbeworthathousandwords,you’llfindanexampleoranillustration.Unlikemostpublicationsonfinance,wegiveyounotjustthehowbutalsothewhyofthefinancialprocess.Ourgoal:tobringyouuptospeedfastonthefinancialtoolsyouneedtosucceedinbusinesstoday.
2 / Business Management Daily
AreYouSavvyAboutFinance?
Beforereadingthisreport,youmightfinditinterestingtotestyourcurrentknowledgeoffinance.Takethefollowingtestandcheckyouranswersbelow.
True False
1. Small companies generally use “S-1” ❏ ❏ public stock registrations in their equity offerings.
2. Another name for “income statement” is ❏ ❏ “statementoffinancialchanges.”
3. “NPV” stands for “net percentage value.” ❏ ❏
4. Fixed costs are so named because they ❏ ❏ never change.
5. A current ratio gives you a good ❏ ❏ indicationofacompany’sprofitability.
6.Non‑notificationfactoringridsa ❏ ❏ company of the chore of handling bookkeeping and collection payments for its receivables.
7. “Hurdle rate” is just another name for ❏ ❏ “current loan rate.”
8. The payback method is a good way to ❏ ❏ measuretheprofitabilityofacapital project.
9.Acompany’sfirststepinthebudget ❏ ❏ process is to come up with a cash forecast.
10. “Working capital” is a fancy label for ❏ ❏ acompany’scashflow.
Answers: All 10 questions are false.
Mastering Business Finance / 3
Learning the Tools of the Trade
Togetthebigpictureoftherolefinancesplayinyourcompany,thinkaboutanymajordecision youorotherswithinyourcompanymake.Thedecisionstohire,fire,buy,sell,startuporclose
down—allarefinancialnature.Almostanyquestionthatmakesitswaytoyourdesk,andthatrequiresadecisionbyyou,canbeputintofinancialterms.
Inthestrictestsense,thefinancialproorofficerinyourcompanyisstilltheonechargedwithmakingsurethecompanyusesitsassetstobringthegreatestpossiblereturnonthemoneyin-vested.Toaccomplishthat,heorshemustmanagethoseassets,measuretheneedforadditionalassets,obtainfundstofinanceexpansionandrepayborrowedfundsfromprofitsthattheassetshavegenerated.Inshort,thefinancialofficerridesherdonincomingandoutgoingdollars.But,infact,everymanagerhasatleastpartofthatresponsibility.
Itshouldcomeasnosurprisetoyou,then,thatthebasictoolsofthetradeusedtocarryoutthesetasksbeginandendindollarsigns.Theyarecalledthebalance sheet,theincome statement andthestatement of cash flows.Thesefinancialstatementsarepreparedbyyouraccountingde-partmentoraccountantontheaccrualbasisofaccounting.Accordingtotheaccrualaccountingmethod,revenuesarerecordedwhenrealizedandexpenseswhenincurred,regardlessofthedatewhencashisactuallyreceivedordisbursed.
Formanynonfinancialmanagers,theaccrualconceptisconfusingbecausemostofusmanageourpersonalfinancesonacashbasis.Similarly,otherbusinessfinancialconceptscreatefrustra-tionandembarrassmentformanagerswho,oftenunknowingly,attemptto“simplify”thingsbyapplyingpersonalfinancialpractices.
Forinstance,mostofusregardourannualincomeonagrossbasis.Rarelydoweconsiderdepreciatingpersonalitems,suchasacarforwearandtear,oramortizinglesstangiblegoods.Anexaminationofthebalancesheet,incomestatementandstatementofcashflowswillrevealtheimportanceofunderstandingthedifferencebetweenbusinessandpersonalfinance.
TheBalanceSheetThebalancesheetisacomprehensivestatementofthefinancialpictureofyourcompanyonagivendate.Virtuallyeverybusinesspreparesabalancesheetatthecloseofitsfiscalortaxyear.Manyalsopreparesemiannualorquarterlybalancesheets,andmostshoulddoso.
Therearetwoprimarysectionsonthebalancesheet:Thefirstone(theleftside,ifthetwosectionsareshownsidebyside)listsyourcompany’sassets,orwhatitowns.Thesecondsection(right-handside)listsliabilities,ordebts,andtheowner’sequityinthecompany.Totalliabilitiesareclaimsagainsttotalassets.Thesumoftheseliabilitiesandequityalwaysequalstotalassets(assets=liabilities+equity):hence,thename“balancesheet.”Thesimplifiedbalancesheetthatappearsonpage4mightbepreparedbyanymanufacturingcompany.Othercompanieswouldhavesimilarstatements.
1
3
4 / Business Management Daily
Sample Corporate Balance Sheet
ASSETSCurrent assets
Cash and equivalents $ 30,000 Trade accounts receivable $80,000 Less allowance for doubtful accounts 9,000 71,000
Inventories Finished goods/products 65,000 Work in process 65,000 Raw materials 10,000 Supplies 5,000 145,000
Prepaid expenses 9,000
Total current assets $255,000
Fixed assets Furniture and fixtures $ 9,000 Less allowance for depreciation 4,000 5,000 Machinery and equipment 20,000 Less allowance for depreciation 6,000 14,000 Buildings 35,000 Less allowance for depreciation 8,000 27,000 Land 14,000 Total fixed assets 60,000
Other assets Investments 15,000 Goodwill, patents 8,000 Total 23,000
Total assets $338,000
LIABILITIES AND EQUITYCurrent liabilities
Accounts payable $ 30,000 Notes payable 70,000 $100,000
Accrued liabilities Wages and salaries payable $ 3,000 Interest payable 1,000 4,000
Allowance for taxes Income tax $14,000 State taxes 3,000 17,000
Total current liabilities $121,000
Long‑term debt 5,000
Equity
Capital stock $150,000 Surplus 62,000 Total equity 212,000
Total liabilities and equity $338,000
Mastering Business Finance / 5
Followingisadescriptionofeachofthebasicbalance-sheetitemslisted,manyofwhichwillbeusedtoconstructthevariousfinancialratiosexplainedinSection2.
Assets
Current assets:Allcashheld(primarilyinbankbalancesormoneymarketfunds);assetsthatwillbeconvertedtocashinthenormalcourseofbusinesswithinonebusinessyear(tradeaccounts,notesreceivableandinventories);plusotherassetsthatcouldorwillbeconvertedwithinayear(marketableshort-termsecurities,nontradedebtsordebtinstallmentsowedtothecompanywithinayear).Otherthancashandequivalents,currentassetsincludeinventories(invariousstagesofcompletion)andprepaidexpenses(anyrent,interest,insuranceortaxespaidinadvance).
Althoughthetermdoesn’tappearinmostbalancesheets,thefollowingitemsmakeupnon-current assets.
Fixed assets: Allproperty,plantsandequipment(buildings,realestate,machines,transporta-tionequipment,officeequipment,furniture,etc.)usedinthebusiness.Theaccumulateddeprecia-tionontheseitemsisdeductedwhereapplicableinstandardaccountingpractice.
Other assets:Alllong-terminvestments,suchassecurities(stocks,bonds,mortgages),andintangible assets,suchasgoodwill,patents,trademarksandotherpaperassets,whichmaybeassignedavaluefordeterminingthetotalsalepriceofthebusiness.Intangibleassetscanhaveasignificantimpactonabusiness’sabilitytogenerateincome.However,unlikeaplantorequip-ment,theyareoftenconceptsorlegalentitlements.
Total assets: Thesumofthecurrent,fixedandotherassetslistedabove.
Liabilities and Equity
Current liabilities:Outstandingtradedebtsandobligations(tradeaccountspayable,short-termnotesandloanspayable,currentinstallmentsdueonlong-termdebts,etc.)thatwillfalldueinthecourseofnormalbusinesswithinoneyear,plusaccruedbusinessexpensespayableandaccruedfederalincometaxespayable.
Long-term liabilities or debt:Allbusinessdebtsandliabilities(long-termloans,bonds,mort-gages,etc.)payablemorethanoneyearbeyondthedateofthebalancesheet.
Total liabilities: Thesumoftheaboveitems.Shareholders’ equity (net worth):Theparvalueofthecorporation’scommonandpreferred
stock,plusanypaid-inoraccumulatedcapitalsurplusoverthisparvalue,plusanyretained earn-ings foruseinbusiness.Retainedearningsofthebusinessrepresentthetotalincomeearnedbythefirmoveritslifelessanydividendspaidouttotheowners.(Equity=bookvalueofoutstandingstock+capitalsurplus+retainedearnings)
Total liabilities and equity: Thesumoftheabovetwogroups,whichbydefinitionisalsoequaltothetotalassetsofthebusiness.
TheIncomeStatementTheincomestatement(alsocalledtheearningsreportorprofit-and-lossstatement)reflectstheresultsofoperationoveraperiodoftime,incontrasttothebalancesheet’ssnapshotviewofthecompany’sfinancialconditionatagiveninstant.Again,everybusinessmustprepareanannualincomestatementfortax,legalandotherpurposes;nevertheless,semiannual,quarterlyorevenmonthlystatementscanbeextremelyuseful.Theitemsincludedinthesimplifiedincomestatementonpage6willoftenbeneededtocreatethefinancialratiosusedinyouranalysisandcoveredinthenextsection.Briefly,hereisadescriptionoftheitemscontainedinacompany’sincomestatement:
6 / Business Management Daily
Gross sales or revenues: Theactualtotaldollarsbilledforgoodssoldorservicesprovided,beforereturns,discountsandallowancesgranted.Salesincomeandaccountsreceivabledeterminethisfirstlineitem.
Net sales or revenues: Grosssalesminusreturns,discountsandallowances.Cost of goods sold:Theamountspaidforthepurchasedmaterials,componentsandfinished
products;directpayroll,operatingoverhead;andothercostsofacquiringorproducingtheprod-uctsorservicesandmakingthemavailableforsale.Thislineitemoftenappearsasless cost of goods sold.
Gross profit:Thedifferencebetweennetsalesorrevenuesandthecostoftheproductsorservicessold.Thisrepresentstheamountofmoneylefttoselltheproductandperformtheday-to-dayoperationsofthebusiness.
Selling and administrative costs:Sellingcostsincludesalespersons’salariesandcommissions,travelandentertainmentexpenses,salespromotionandadvertisingcosts.Administrativecostsincludeofficesalariesandexpenses,executivesalariesandothercurrentsupportexpensesthatcan’tbeallocatedtoproductionorsalesdepartments.
Depreciation: Thecostsofplantassets(orfixedassets:property,plantandequipment)arewrittenoffasexpensesover theiranticipateduseful life.Notallfixedassetsaredepreciated,however.Forinstance,thevalueoflandtendstoappreciateinvaluebecauseitdoesnottypicallywearout.Therearevariousdepreciationtechniquesanaccountantcanuse.ThesimplestandmostcommonlyusedmethodinU.S.businessesiscalledthestraight-line method of depreciation,whichallowsyoutodepreciatethesameamountofexpenseeachyearoftheestimatedusefullifeoftheasset.Forexample,anassetwithavalueof$10,000andausefullifeof10yearswillhaveanannual$1,000depreciationexpenseeachyear.
Net operating profit:Grossprofit,lesssellingcostsandadministrativeoverhead.Thislineitemrepresentstheprofitgeneratedbythenormaloperationsofthebusiness.
Nonoperating income: Interestanddividendsreceivedoninvestments,gainsonthedisposi-tionofcapitalassets,etc.
Nonoperating expenses:Interestpaidonlong-termdebts,lossesonsalesofcapitalassets,etc.
Sample Income Statement
Gross sales or revenues $ 605,000
Returns, discounts and allowances 30,000
Net sales or revenues 575,000
Cost of sales or goods sold 470,000
Gross margin or operating profit $ 105,000
Selling and administrative costs 60,000
Depreciation 5,000
Net operating profit $ 40,000
Interest income or nonoperating income 10,000
Interest expense or nonoperating expense 3,000
Net profit before taxes $ 47,000
Provision for federal income taxes 10,000
Net profit after taxes $ 37,000
Mastering Business Finance / 7
Net profit before taxes:Netoperatingprofit,plusanynonoperatingincomeandminusanynonoperatingexpenses.
Provision for federal income taxes:Theestimatedamounttobepaidonoperatingearningsfortheperiod,nottheamountoftaxespaidduringtheperiod.
Net profit (or income) after taxes: Thefinal“bottomline”profitclearedbythebusinessfromallsourcesduringtheperiodcoveredbythestatement.Usingthisvitalfigure,stockholderscanevaluatemanagement,investorscandecideonwhethertopurchasethecompany’sstock,andcreditorscanmeasuretheriskinessofaloan.
The Statement of Cash FlowsThestatementofcashflows,whichshowsthemovementofcashthroughabusiness,presentsthecashreceiptsandcashpaymentsofacompanyoveraperiodoftime.Itcomplementstheincomestatementbyprovidinginformationonacompany’sliquidityandfinancialflexibility.Italsoex-plainsthechangeofcashandcashequivalentsduringaperiod.(Cashequivalentsareshort-term,highlyliquidinvestmentsthatarereadilyconvertibletocashamounts,suchasshort-termTreasurybills,commercialpaperandmoneymarketfunds.)Insimilarfashiontothebalancesheetandtheincomestatement,thestatementofcashflowsmustbepreparedannuallybyeverybusinessbutmayalsobedonesemiannuallyorquarterly.
Note: EffectiveforannualfinancialstatementsforfiscalyearsendingafterJuly15,1988,thestatementofcashflowssupersedesthestatementofchangesinfinancialposition,whichtheFi-nancialAccountingandStandardsBoard(FASB)formerlyrequired.Not-for-profits,however,arenotrequiredtomaketheswitch-over.
Byusingthestatementofcashflowsinconjunctionwithinformationprovidedbythebalancesheetandtheincomestatement,companyowners,creditorsandotherswhousefinancialstate-mentscanassessacompany’sabilitytogeneratefuturenetcashinflows,meetdebtobligationsandpaydividends.Thestatementshouldalsohelpinassessingacompany’sneedforfutureexternalfinancing,aswellastheeffectsofbothcashandnoncashinvestingandfinancingactivitiesonacompany’sfinancialposition.
Thestatementofcashflowsisclassifiedbyoperating,investingandfinancingactivities.(See sample statement on page 8.) Briefly,thesearetheitemscontainedinacompany’sstatementofcashflows:Operating Activities: Cash received from: ● Saleofgoodsorservices. ● Collectionsorsalesofreceivablesthat
arise fromthesalesofgoodsandser-vices.
● Interestonloansandbonds. ● Dividendsonequitysecurities. ● Insuranceandlawsuitsettlements. ● Refundsfromsuppliers.
Cash paid to: ● Acquisitionofmaterials for inventory
ormanufacturingproducts,orforgoodsforresale,includingpaymentsontradeaccountsandnotespayabletosuppliers.
● Creditorsforinterest.
● Employeesforcompensation. ● Governmentalagenciesfortaxes,duties,
fees,finesorpenalties. ● Customersforrefunds. ● Lawsuitsettlements. ● Charitiesforcontributions.
Investing Activities: Cash received from: ● Salesofproperty,plant,equipmentand
otherproductiveassets. ● Salesofabusinessunitsuchasabranch,
divisionorsubsidiary. ● Collectionsofprincipalondebtinstru-
mentsofothercompanies. ● Saleofloans.
8 / Business Management Daily
Cash paid to: ● Acquireproperty,plant,equipmentand
otherproductiveassets. ● Acquireanotherbusiness. ● Make loans toand/orpurchase loans
fromanothercompany. ● Acquiredebtorequityinvestmentsin
othercompanies.
Financing Activities: Cash received from:
● Issuing equity instruments, such asstockinthecompany.
● Issuingbonds,mortgages, notes andotherformsofshort-termorlong-termborrowing.
Cash paid to: ● Ownersofthecompanyintheformof
dividendsorotherdistributions. ● Repayment of amounts borrowedon
short-termandlong-termdebt.
Sample Statement of Cash Flows
Cash flows from operating activities Cash received from customers $110,000 Cash paid to suppliers and employees ( 90,000) Interest received 8,000 Interest paid ( 6,000) Income taxes paid ( 9,000) Net cash provided by operating activities $13,000
Cash flows from investing activities Proceeds from sale of plant $70,000 Purchase of equipment ( 10,000) Net cash provided by investing activities $60,000
Cash flows from financing activities Principal payments on notes ($40,000) Dividends paid ( 15,000) Net cash used in financing activities ($55,000)
Net increase in cash and equivalents 18,000
Cash and equivalents at beginning of year 12,000
Cash and equivalents at end of year $30,000
Reconciliation of net profit to net cash provided by operating activities: Net profit after taxes $37,000
Adjustments to reconcile net profit after taxes to net cash provided by operating activities: Depreciation 2,000 Gain on sale of plant (11,000) Increase in trade accounts receivable ( 7,000) Increase in inventory (10,000) Decrease in accounts and notes payable 5,000 Increase in interest and taxes payable ( 3,000)
Net cash provided by operating activities $13,000
Mastering Business Finance / 9
Themoststraightforwardwaytopresentoperatingactivitiesinastatementofcashflowsisthedirectmethod,whichreportsmajorclassesofoperatingcashreceiptsandpayments.Underthismethod,aseparatescheduleispresentedwiththestatementofcashflowsthatreconcilesnetprofitandnetcashflowfromoperatingactivities.Ineffect,thisreconciliation isaconversionofnetprofitfromtheaccrualtothecashbasisofaccounting.
➤ Observation: You’llfindthebalancesheet,theincomestatementandthestatementofcashflowsinacompany’sannualreport.Inmostannualreportsthesefinancialstatementsarepre-sentedonacomparativebasis:thatis,thecurrentyearalongwithoneormoreprioryears.Usethefiguresinthesestatementstoanalyzeyourowncompanyaswellasyourcompetition,toforecastthefinancialoutcomeforyourentirebusinessordepartmentproject,andtomakeavarietyofotheressentialbusinessdecisions.Inshort,thesereportsarethreeofthebusinessperson’smostimportanttools.
10 / Business Management Daily
How the Financial Pros Use These Tools
Nowthatyouareawareofthemechanicsofabalancesheet,anincomestatementandastate- mentofcashflows,yourworkisnotoveryet.Keepinmindthatalthoughthefiguresin
thosereportsareimportant,theydon’t,inandofthemselves,tellyouhowyourcompanyisdoingcomparedwithothersinyourindustry,whetherithasstayingpowerinourhighlycompetitiveworldorwhatweaknessesitshouldbecorrectingfromwithin.Inshort,thosereportsalonedonottellyouwhetherthecompanyisfinanciallyhealthy.
Todeterminethefinancialstateofyourcompany,youhavetoturntothreemajorconditionswithinyourcompanythatyou,asamanager,canhelpcontrolorchange:● Liquidity,whichissimplytheabilitytogenerateenoughcashtopayyourbillsandexpenses
ontime.● Leverage,whichistherelationshipbetweenyourcompany’stotalliabilitiesandequity.Your
firmissaidtobehighlyleveragedwhenithasa lotofdebt inrelationtoequity.Insomeinstances,carryingalotofdebtcanbeadvantageous.Atothertimes,itcanbeinjurioustoacompany’shealth.Thoseprosandconswillbediscussedlaterinthissection.
● Profitability,whichissimplywhetheryourcompanyendsupwithanymoneyafterallyourexpenses, including taxes,havebeenpaid.Profitability, inotherwords, is reflected in the“bottomline”ofyourincomestatementanddetermineswhetheryoushouldbeinbusinessatall.
TroubleshootingWithRatioAnalysisFinancialanalystsexaminetheliquidity,leverage,profitabilityandothervitalaspectsofafirmbyusingthefiguresinthecompany’sfinancialstatementstoformspecialrelationshipsorratios.Theseratiosarethemostcommonsourceofinformationtheyusetoassesstheperformanceofabusiness.Theycanrelateanyaspectofyourbusinesstoanyotherarea,suchassalestoprofits,orprofitstoassets.Mostimportant,becausetheyaresowidelyusedandreported,itispossibletocompareratiosforyourownbusinesswiththeaverageforyour industry,orforgroupsofcompanieswithinyourindustry.
Sometimes,however,ratioanalysiscanleadyouastrayifyouarenotawareofitslimitations.First,ratioanalysisisgearedtowardgivingyouinsightsratherthanhardbusinessdata.Assuch,itcanpointthewaytopossibletroublespots,butyouwillneedfurtherverificationwhenyougetthere.Forinstance,adownturninyouroperatingprofitmarginmightpointoutanoperatingbottleneck,butyouwillneedtoinvestigatefurthertoisolatetheproblem.Moreover,ratiosdealwithhistoricaldata,whichmayormaynotberelevanttocurrenteconomictrendsorcompanyneeds.Forthisreason,itisalwayswisetoconfirmthatatrendindicatedbyaratioanalysisis,infact,applicabletocurrentoperatingconditions.
TenCriticalRatiosRatioscomeinallshapesandsizes,andareapplicabletoawiderangeofbusinessproblems.Morethan150financialratiosarecurrentlyinuse.Forourpurposes,wehavechosen10ratios,eachaddressingaspecificpotentialproblemareaandderivedfromthebalancesheetand/orincome
2
10
Mastering Business Finance / 11
statement.These10criticalratiosarebasicanalyticaltoolsformostbusinesses.Thefollowinglistdetailstheircomponentsandprincipalsignificance:
1. Current ratio:Totalcurrentassets,dividedbytotalcurrentliabilitiesatthesamepointintime.Thestandardtestmeasureoftherelativeadequacyofworkingcapital,oroftheliquidity ofthebusiness.Recommendation:Generally,healthyfirmsaimfora2to1currentratio,whichmeanstheyhave$2incurrentassetsforevery$1ofcurrentliabilities.
2. Debt/equity:Totalcurrentandlong-termliabilitiesdividedbyaverageshareholders’equity.Measurestheleverage,ortheextenttowhichthebusinessdependsonborrowedcapital,andwhethercreditorsortheownershavealargerinterestintheenterprise.Recommendation: Asageneralrule,thisratioshouldequalroughly.6.
3. Return on equity:Netprofitfortheperiod,dividedbyaverageshareholders’equityfortheperiod.Thisisthetruereturnonthenetinvestmentoftheowners’capitaltiedupinbusiness,andthemostbasicratiointhefamilyofreturn on investment (ROI) ratios.Thisratio,alongwithratioNo.4,measures the thirdconditionyou’re lookingat inanalyzingacompany:profitability.Recommendation:Thisfigureshouldbe.14orhigher,whichmeansacompanyshouldreturnatleast14percenttobeginsatisfyingitsinvestors.
4. Return on assets:Netoperatingprofitfortheperiod,dividedbyaveragetotaltangibleassetsfortheperiod.ThisisanotherratiousedtomeasuretheROIofthetotalcapitalbeingusedinthebusiness.
5. Net profit margin:Netprofitdividedbynetsalesforthesameperiod.Thiskeymeasurereflectsthesuccessfulorunsuccessfulinteractionofsalesefforts,pricesandcostsovertheperiod.Recommendation:Usethisratiotocompareyourfigureswiththoseofothercompaniesinyourindustry,ortocomparenetprofitonsalesforindividualproductsorproductlines.Asamanager,youcanthenrecommendwhichproductsshouldbepromotedordropped.Note:Ratios6through9aregenerallyreferredtoasoperating ratios.Theyaremostusefulwhenmakinghistoricalcomparisonswithinthecompanyorwithothersinyourindustry.
6. Receivables turnover:Creditsalesdividedbyaverageaccountsreceivablefortheentireperiod.Ameasureofrelativehealthofoutstandingreceivables,inthatthehighertheratio,thefasteraccountsarebeingpaidup.
7. Inventory turnover:Costofgoodssolddividedbyaverageinventoryfortheperiod.Thisisayardsticktomeasuretherelativeadequacyofinventories,orthespeedwithwhichinven-toriesareturnedover.Iftheratiokeepsdecreasing,yourcustomer’sinventoriesareprobablyexcessiveanddrainingneededcash.Iftheratiosuddenlyrises,inventoriesmaybetoolowandthusmayendangerproductionschedules.
8. Fixed-asset turnover:Netsalesdividedbygrossplantandequipment(beforedepreciationdeduction)fortheperiod.Thisisanindexoftheamountoffixedcapitalrequiredtoproduceeachsalesdollar.Itisusedtodeterminewhetheryou’reusingyourfixedassetsefficiently.
9. Total asset turnover:Netsalesdividedbyaveragetotaltangibleassetsfortheperiod.Amea-sureoftheeffectiveemploymentofthetotalassetsofthebusiness.
10. Equity turnover:Netsalesdividedbyaverageshareholders’equityfortheperiod.Thisisthebasicmeasureforcomparingsalesproducedbytheowners’netinvestmentwiththatofothercompanies,periodsorindustries.Theratioindicatestheturnoverofinvestmentcapital,orhowhardtheinvestedcapitalisworking.Thereisn’tanygeneralnormforthisratio;eachlineofbusinesssetsitsown.
Nowlet’stakealookatthepracticalapplicationsofsomeoftheseandotherratiosbyaskingthefollowingquestions:
12 / Business Management Daily
Does your firm have enough cash to pay its bills?
Lackofcashcanbeamajorproblemsimplybecausecashinflowisuncertain,whiletherequiredcashoutflowisconstantandnecessarytomaintainregularbusinessoperations.Forthatreason,abusinessmusttrytomaintaincertainlevelsofcashtopayitsbillsbymaintainingasafecurrent ratio.Inotherwords,itkeepsaneyeonitsliquidity.
Example:Inoursamplebalancesheet(see page 4),thecurrentratiowouldbe:
Currentassets($255,000) Currentliabilities($121,000)
Oursamplecompanyseemstohaveadequateliquidity.
To leverage or not to leverage?
Ahighlyleveragedcompanyhasitsprosandcons.Manyentrepreneursseekoutaleveragedfirmbecausetheybelievetheycanearnenoughwithacompanybothtopaytheinterestondebtandmakeagoodreturn.Inotherwords,leveragecanincreaseprofits.
Inbadtimes,ahighlyleveragedfirmcanreactthesamewayasanindividualdrowningindebt.Interestpaymentsbecomehardtomeet,andcreditorsbeginclosinginforthekill.Forthatreason,bankersandmanagementpeoplepaycloseattentiontothedebt/equityratiotoseeifthere’sanyunduedrainonfunds.
Example:Againinoursamplebalancesheet:
Totalliabilities($126,000) Shareholders’equity($212,000)
Again,oursamplecompanyseemstobesittingpretty!
How profitable is your firm?
Dependingonhowmuchitwantstomake,everycompanyhasitsownnormforwhatthereturn on equityratioshouldbe.Weused14percentasaminimum.Others,however,saythatthereturnshouldatleastmatchthegoingrateforTreasurybills,orafirmmightbebetteroffusingthecapitalinvestedinthefirmforsomeotherpurpose.
Example:Forthisratio,weturnbothtoourbalancesheetfortheequityfigureandtotheincomestatement(see page 6) forthenetincomefigure:
Netincome($37,000) Equity($212,000)
Itlookslikeoursamplefinancialstatementsindicateaveryhealthycompany.
Should you provide credit to a customer?
Often,youwillneedinformationfromacustomertobeabletoanswerthisquestion.Whenthecustomerprovidesabalancesheetorincomestatement,youneedtoknowwhattolookfor.Practi-callyspeaking,theincomestatementislikelytobeoutofdateandwon’trepresentthecompany’scurrentfinancialaffairs.Mostcompaniesprepareincomestatementsonlyonceortwiceeachyear,butmonthlybalancesheetsarecommon.
=2.1
=.59
=17%
Mastering Business Finance / 13
Ifyouobtainanup-to-dateincomestatement,itwillnotrequiremuchadditionalworktocomeupwithacompletepictureofthecompany’scurrentstateofaffairs.Luckily,evenwithoutacurrentincomestatement,youcanlearnmuchfromthebalancesheetbyusingratioanalysis.Asyoucansee,mostratioanalysisrequiresonlybasicmathskills.
Fromourlistof10criticalratios,usethecurrentratiotodeterminewhetherthecustomerisliquidenoughtopayoffdebts,andusethereturnonequityratiotoseewhetherthecustomerisprofitable.Usetheinventoryturnoverratiotodetermineifthecustomerwillbeabletomeetyourproductionschedules.Whenusingratiosthatrequiresalesfigures,thoseforthelatestyearavailablewillsuffice.Inaddition,thefollowingratiosareimportant:● Current liabilities to net worth:howmuchofthefundsinvestedbyyourcustomerswould
beneededtopayoffallshort-termobligations.Thelowertheratio,thebetter.Normally,youshouldshyawayfromafirmwitharatioof66percentorhigher.
● Short-term debt coverage: currentassetsdividedbyshort-termdebt.Thisratioisavariationofthecurrentratio,withtheemphasisonshort-termdebt(debtduewithinoneyear).Ifyourcustomerhas$2ofcurrentassetstocovereach$1ofdebt,youaresafe.A1:1ratiowillsufficeifthecurrentassetsareeasilyconvertedintocash.
● Average collection period: accountsreceivabledividedbycreditsalestimes365.Thisratiowillgiveyouagoodideaofhowfastyourcustomeriscollectingitsbills.Usually,35–45daysisconsiderednormal.Anythingover50daysmayindicatesizableuncollectibleaccountsandshouldgiveyoujustcauseforconcern.
Example: Ifacompanywith$20million increditsalesmaintainedaccountsreceivableof $2million,theaveragecollectionperiodwouldbe36days($2million÷$20millionx365=36.5).
➤ Observation:Onceyoudecidethatanewcustomerhasthewherewithaltopaybillsontime,youmustdeterminehowmuchcredittoextend.Ageneralruleofthumbistofillanyfirstorderupto10percentofthecustomer’snetworthand,afterthat,openaformallineofcredit.Onceapproved,thislineofcreditshouldbeexceededonlywithtopmanagement’sapproval.
14 / Business Management Daily
AnsweringSomeDifficult FinancialQuestions
Ratioanalysiscanbeveryhelpful inpinpointingoperating inefficiencieswithinyourcom- pany.Buttounderstandhowyoucanuseratiostospotproblems,youmustfirstknowthe
rightquestionstoask.Inthissectionweaddresssomeoftheimportantfinancialquestionsthatallmanagersshouldbeasking.
AQuestionofProfitMarginsHas profit growth kept pace with sales growth in recent years? If not, have some markets been more responsible than others for the lag?
Manymanagerswronglybelievethatasacompanygrowsandmatures,profitsalwaysin-creaseataslowerratethansales,evenasbothcontinuetoexpand.Thisiscalledtheprincipleofdiminishingreturnsonaddedvolume.However,thisprincipleisoftenuntrue.Considerthefollowingexample.
Amanufacturerofsmallpartsandcomponentsforfinishedproductsfoundthateconomiesofscaleandothergrowthfactorswerenolongerbringingsatisfactoryprofitgrowth.Rather,itappearedthatincreasedsalesvolumehadcomepartlyfromitsentryintonewmarketsthatweremorecompetitive,moreexpensivetopromoteandserve,andgenerallylessprofitable.
Oneof thefirst analyticalfigures the topmanagers turned towas the familiarnet profit margin,onamarket-by-marketbasis.Tobegin,thefirm’ssalesanalystproducedreportsshowingnetprofitmarginsonsalesbymarketsforeachofthelastthreeyears.Thesereportsshowedallthecostsassociatedwithgettingthesaleandsubtractedthemoutofthegrosssalesfigure.Theseresultsservedasanimportantfactorindecisionsthatlaterledtomajorchangesinthecompany’soverallmarketingstrategy.
Afewoftheindustrygroups,forexample,hadgrowninbothsalesvolumeandprofitabilityoverthepastfewyears.Severalothersaccountedforalargershareofcompanysales,butrevealedshrinkingprofitmarginsinthisanalysisasaresultofsubstantialpricediscounting.Forthetimebeing,atleast,littlecouldbedoneaboutsomeoftheseindustrymarketsbecausethecompanyneededthevolumetheygenerated.
In someof themosthighly competitive industrymarkets,however, analysis showed thecompanywasforgoingprofitswithoutsubstantiallyimprovingitsmarketposition.Furthermore,thetopmarketingpeopleagreedthattherewaslittlelikelihoodofchangingthissituationforthebetterinthenearfuture.Managementdecidedtodeemphasizesaleseffortsinthesemarkets,ex-ceptatfull-profitpricing.Althoughsalesvolumefelloff,thesaleseffortswereretargetedtomoreprofitableindustrysectors.Itwasnotlongbeforethegrowthtrendforoverallnetprofitreverseditsdeclineandslowlybegantoimprove.
Sometimesacompany isunable tobreakdownall itssellingandadministrativecostsbymarketsegmentorsimilarcriteria.Onealternativeissimplytoallocatethesecostsinproportiontothesalesvolumeinthemarketsegmenttowhichtheyarerelated.This,ineffect,assumesthatsellingcostsaremoreorlessuniforminthevariousmarkets,whichmaynotbethecase.
Often,youcanmakeausefulanalysisbydividing grossprofit,insteadofnetoperatingprofit,bynetsales.Thisgross profit marginiswidelyusedinretailingandothernonmanufacturingindustries.
3
14
Mastering Business Finance / 15
Stillanotheroption,whensellingandadministrativecostscannotbefullyallocated,istocal-culatetheratioofgross profit to cost of goods soldinadditionto,oreveninsteadof,theaboveratios.Thisratiocanbeparticularlyusefulinfieldswherebiddingpricesarecalculatedandquotedoncontractsonthebasisofproductioncostestimates.Comparisonsovertime—betweenmarketsorevenbetweencustomers—canrevealpreciselytowhatdegreeprofitsacrificesarebeingmade,intermsofthelowerprofitreturnonproductionoutlays,toobtainvolume.
➤ Observation:Inthisandotherinternalratioanalysesinvolvingprofits,theincomestate-mentitemtostartwithisthenetoperatingprofit,ratherthanthebroadernetprofitbefore(orafter)taxes.First,federalincometaxrateschangefromyeartoyearandwiththesizeofcompanyprofits,sousingafter-taxprofitsforinternalpurposeswouldmerelyintroduceacomplicatingfactor,nottomentiontheneedtoallocateonemoreitem.Second,becausethevariousinternalcomparisonsbeingmadearealwaysbetweenoperatingpartsofthebusiness,theinclusionofanynonoperatingincomeorexpensewoulddistorttheresults.Insomelinesofbusiness,accountantsandindustrygroupsusetheprofitconceptof“earningsbeforeinterestandtaxes”(EBIT),whichisroughlythesameasnetoperatingprofitplusdepreciation.Thisfigureeliminatesbothfederalincometaxesandinterestearnedorpaidonlong-terminvestmentsanddebts.
AQuestionofWorkingCapitalDo you have enough working capital to take advantage of investment opportunities? If not, are some of your departments more to blame and need more tightening up than others?
Thedollardifferencebetweenanybusiness’scurrentassetsanditscurrentliabilitiesisaptlycalledworking capital.Thisistheamountofreadycashandreadilyconvertibleassetsthatyoucanput toworkasneeded,without leaving thecompany inadangerouslyexposedfinancialposition.Workingcapitaliswhatenablesyourfirmtotakeadvantageofspecialdeals,earncashdiscounts,borrowshort-termfundsmoreadvantageouslyorcapitalizeonsimilarprofitoppor-tunities.Italsoenablesthecompanytomeetitstradeobligationsanddebtinstallmentsontime.Theratiomostcommonlyusedtomeasuretheadequacyofworkingcapitalisthecurrent ratio.
Retailoperationsregularlyapplythecurrent-ratioapproachfor internalanalyses,suchascomparing thecreditandfinancialperformancesof theprincipaldepartmentswithinvariousstores,aswellascomparingstoreswitheachother.
RMA’sAnnual Statement Studies
A good way to compare your company’s ratios with other companies’ is to obtain a copy of the Risk Management Association (RMA) Annual Statement Studies. These studies are culledfrommorethan86,000financialstatementsofbankborrowersreviewedbyRMA,anationalorganizationofbanklendingofficers,andtheyincludeinformationoncloselyheld companies and public corporations.
Thedataisclassifiedintotwomainsections:Thefirstcontainscompositebalancesheetandincomestatementcomparisonsforeachof355industriesforthepastfiveyears.Thesecond section contains 17 commonly used ratios, presented as medians and quartiles, for most of the industries. With that information, a manager can zero in very quickly on where a company stands. For further information, go to www.rmahq.org.
16 / Business Management Daily
Toconstructthecurrent-assetscomponentofthesedepartmentalratios,itisarelativelysimplematter tocollectcurrentdataonaccountsreceivable (fromthedepartmentalcodingoncreditcustomers’billing)andoninventories(directlyfromdepartmentrecords).Thesetwocategoriesaccountforthelargestshareoftotalcurrentassetsfoundinthistypeofbusiness.
Forthecurrent-liabilitiescomponent,itisequallysimpleformanagerstobreakdowntradeaccountspayablebydepartmentsbyusingvendorcodesandmerchandisecategoryinformation.Someoftheremainingshort-termdebtsandexpensespayablecanalsobeallocateddirectlytodepartmentswithreasonableaccuracy.Anallocationofremainingcurrentliabilitiesinproportiontodepartmentalvolumedoesnotbiastheresultsinanysignificantway.
Onthecurrent-assetsside,retailoperationsgenerallyapplyanotherratio—receivables turn-over—tohelpanalyzetheirworkingcapitalpositions.
Theidealdepartmentinaretailoperationisonethatbothcontributestoworkingcapital,reflectedinahighcurrentratio,andhasanacceptablerateofreceivablesturnover,indicatedbyalowlevelofoutstandingreceivables.
AQuestionofReturnsWhich areas of the business will provide the best return on an increased investment of capital? How profitably is each area using the assets now assigned to it?
Whereshouldyourcompanyspenditsinvestmentdollars?Intechnology?Salesdevelopmentandtraining?Buildingawarehouse?Perhapsinproductdevelopment?Todetermineacompany’slong-termstrategy,youmustknowwhat thereturnswillbe.Wecan illustrate this importantconceptthroughthefollowingexample.
Adistributorofcleaning/maintenancetoolsandsuppliesoperatesthreedivisions,eachaimedatadifferentmarket:(1)contractandinstitutionalsales,whichsellstolargebuildingmanagementfirms,maintenancecontractors,majorhospitalsandsimilarpurchasers;(2)industrialproducts,whichsellstocommercialandindustrialcustomerslargelythroughagents;and(3)consumerproducts,whichmarketsbrandedandunbrandeditemsthroughretailstores.Themanagersofallthreedivisionshavedemonstratedthattheycouldimprovetheirvolumeandmarketshareswithinfusionsofcapitalforpackaging,warehousing,deliveryandotherequipment.Thecompanyhasdecidedtoaddtoitscapitalinvestmentbutmustdecidewhichdivisionshouldbeallocatedthelion’sshareofthefundinginordertomaximizethereturntoshareholders.
Return on shareholders’ equityiswhatthecorporation’stopmanagerswillbelookingatfirstinthiscase.It’sreasonableforthemtoassumethatthedivisionwiththehighestpresentrateofreturnwillcontinuetoearnthebestreturnasitgrows.Andtheyacceptthepropositionthat,withinpracticallimits,allthreedivisionswouldshowthesamerateofsalesgrowthinproportiontoaddedinvestment.
Allocating shareholders’ equitydirectly to the threeoperatingdivisionsmay seem likeadifficulttask.Fortunately,however,thereisapracticalalternativethatreducestheproblemtomanageableproportions.
Constructingthreedivisionalbalancesheets,onecanestimateshareholders’equityineachdivisionbysimplysubtractingliabilitiesfromassets.Thenyoucancalculatethethreereturn-on-equityratios,forbothactualandfutureoperations.
Return on assets (ROA) isanothercritical ratio that topmanagerswillwant toexamine.Somefinancialexpertsbelievethatreturnontotalassetsprovidesthebestmeasureofreturnforacompanybecauseitfocusesonshort-termfinancing.Especiallyintheshortrun,returnonassetshasseveralpracticaladvantagesoverthemorecomplexreturn on equity (ROE)ratio.First,ROAdirectlymeasuresthekeyfactorinvolvedinthedecision:aninvestmentintangibleassets,such
Mastering Business Finance / 17
asstorage,packaging,distributionorotherequipment.Second,itavoidsthenecessityofcon-sideringandallocatingliabilities,whichinmanycompaniesmayinvolvemoreuncertaintyandpotentialerrorthanallocatingassets.Finally,itiseasierfornonfinancialmanagerstounderstandandappreciate—anelementthatcannotbeignoredinreachinganagreement.
Itwouldbewise,however,formanagementtouseboththereturnonassetsratioandthereturnonequityratioinitsanalysis,ratherthanusetheassetsratioasasubstitutefortheequityratio.Theequityratioisthetruemeasureoftheshareholders’returnontheirinvestmentinthecompany,andimprovingthisreturnoverthelongrunisthebasicaimofanymajormanagementdecisions.Moreover,theequityratiomayhighlightcertainimportantresultsofanactualdecisionthattheassetratiowouldnotpickupatall.
Oneelementtakenintoaccountintheequityratio,forexample,willbethedifferingeffectsofvariousassetinvestmentdecisionsonthecompany’sliabilitiesovertime.Ifonedivisionwoulduseitsaddedinvestmentforashort-liveddeliveryfleet,whileanotherwoulduseitforaddedwarehousingspace,theimmediateeffectsontheassetratiowouldbeverysimilar.Theeffectsoverafewyearsonbothassetsandliabilities,andthereforeontheequityratio,however,couldbeverydifferent.Thelatter,ofcourse,wouldbethemoreaccuratemeasureofprospectiveratesofreturnonthealternativeinvestmentproposals.
AQuestionofAssetManagementHave recent volume gains been achieved at the price of a disproportionate tie-up of available assets? For example, have the costs of expanding operations into new territories been worth it?
Inanybusiness—manufacturing,distributionorservices—ittakesaninvestmentoftheown-ers’capitalinthebusinessassetstoproducesalesorrevenues.Incapital-intensivemanufacturingindustriesespecially,theamountofassetsrequiredforeachsalesdollarcanbeoneofthemostcriticalelementsinthecompany’ssuccessorfailure.Knowingjustwherethecompany’sassetsarebeingusedmostandleasteffectivelytocreatesales,therefore,isofvitalconcerntomanagement.
Example:Aregionalmanufacturerofplumbingandheatingsystemsmadeabasicdecisiontosetupassemblyfacilitiesprogressivelyinnewlocations,ratherthanextenditsshippingrangefromitsoriginallocation.Themanagementbelievedthiswasthebestpathtogeographicalexpan-sionofitsmarketingarea.Todate,oneundesirableresulthasbeenasteadydeclineinthedollarsofsalesproducedbyeachdollarofcompanyassets,asthetotalinvestmentinplantandequip-menthasgrown.Topmanagershavethereforebegunacompletereviewoftheoriginaldecisiononterritorialexpansion.
Oneofthemostcriticalnumberstoanalyzeisthetotal asset turnover(netsalesdividedbytotaltangibleassets)andequity turnover(netsalesdividedbytotalshareholders’equity).Athirdratiothatwillbeparticularlyusefulintheanalysisisfixed-asset turnover (netsalesdividedbygrossplantandequipment),whichmeasureshowefficientlyfacilitiesareusedtoproducesales.
Thefigurescommontoallthreeoftheseturnoverratios,forthecompany’spurposes,arethesalesdollarsproducedbyeachofitsterritorialplants,aswellasbythehomeplant.Fortunately,itisasimplemattertoobtaintheneededdollarsalesvolumeinformationforeachplantfromshippingrecordscheckedagainstcustomerbillings.Theotherfiguresinvolvedinmakingupeachratioare,respectively,tangibleassets,shareholders’equity,andtheplantandequipment(p&e)foreachplant.Companyrecordswillproducethep&efigurewithlittle,ifany,adjustmentsrequired.Managementwillhavetoestimatethefirsttwoonaplant-by-plantbasisbyusingthemethodsandassumptionsdiscussedearlier.
Becausethecompanycarriedoutitsterritorialdispersionofproductionandassemblyfacilitiesoveraperiodofyears,managementwillwanttolookattheseveralterritorialratiosastheyhave
18 / Business Management Daily
changedover,say,thelastthreeyears.Thiswillenableittoseejusthowthegeneraldeteriorationincompany-wideratioshasdeveloped,andtopinpointtheterritorialdifferencesineffectivenessthatitexpectstofind.
Considering that the company’s turnover ratioshavedefinitelybeen slipping—andhavecoincidedwiththedispersionprogram—itispossibletospeculateonwhattheanalysisislikelytoturnup.First,aseachnewassemblyplantisbuiltandbroughtonstream,ithasundoubtedlycreatedaninitialdrainontheeffectiveuseofcompanyassets.Becausetheadditionalplantshavebeenactivatedoveraperiodofyears,moreover,thisdrainhascontinuedtoaffectturnoverastheprogramhasdeveloped.Thisfindingalonewouldbereasonforchangingthepolicyoffacilitydispersion.
Managementwillalsoprobablyfind,however,thatwhiletheoperatingfiguresofsometerrito-rialplantshaveimprovedwithtimeastheyandtheirsalesterritorieshavebecomeestablished,othershavepersistentlylagged.Insomecases,thereasonmayturnouttobethatthesizeoftheplantisnotgreatenoughtopermitfullyefficientoperations.Inothers,itmaybethatnotenoughsalesvolumehasdevelopedintheterritorytopermiteffectiveutilizationofthenewfacilities.
Atthispoint,managementneedstobeaskingthesequestions:Willtheplant’sresultsimproveasitssalespotentialisachieved?Shouldtheplantbeenlargedtomakeitmoreefficient,orshoulditbecloseddown?Cantheplantbemademoreefficientbyshiftingorderstoitfromotherter-ritoriesorfromthehomeplant?
AQuestionofDebtStrategyAre we using too much—or too little—borrowed capital in our business? In either event, are we using debt financing and leasing in our various fields of operations to the extent that others do?
Thewords“thecorporationisfreeoflong-termdebt”certainlyhaveasolidringinacreditreport.Yetmanydebt-freecompanieshave,infact,givenupvaluablegrowthopportunitiestoachievethisposition.Andtoday,thosethathaveavoidedfinancingorleasingtoacquirecapitalequipmentandmaterialsmayhavenotonlyrestrictedtheiractivities,butneglectedvaluabletaxbenefitsaswell.
Example:Adiversifiedbusinessserviceorganizationusescopyingandduplicatingequip-ment,offsetprinters,addressingandmailingmachines,wordprocessorsandsmallcomputersinitsoperations.Asservicecompaniesgo,itisarelativelycapital-intensiveenterpriseandmustcontinuallydecidewhethertoownorleasenewitemsofequipment.Ifthedecisionistoown,thereisusuallythefurtherquestionoftherelativeadvantageofacashoutlayversuslong-termfinancing.Atthispoint,companymanagementisconcernedabouttheoverallbalancebetweenownedandleasedequipment,andthemorebasicbalancebetweendebtandcapitalinthebusi-ness.Itwouldliketodecideoneachfutureequipmentacquisitionwiththesebalancesinmindandperhapsevenchangethestatusofsomeofitspresentequipment.
Thedebt/equity ratioistheuniversallyacceptedmeasureoftherelationshipbetweenowner-suppliedcapitalandthatborrowedfromsuppliersandothercreditorsinanybusiness.Ahighratiocomparedwiththatofothersinthesameindustrymaybetakenasawarningsign,butitmayalsobean indication thatyours isanaggressivelygrowing (highly leveraged)companycomparedwiththeaverage.Conversely,alowratiomaymeanthatyou’reinahealthy,conserva-tivedebtposition,butyoualsohaven’tusedtheleverageofdebtfinancingaswellasyoucouldandhavemissedopportunities.
Becausethecompanycompeteswithmailingservices,contractprinters,computerservicebureausandotherspecializedserviceorganizations,itwillwanttocompareitsowndebt/equitypositionwiththoseofaveragecompaniesinasmanyofthesefieldsaspossible.Asastarting
Mastering Business Finance / 19
point,ithascollectedinformationfromtheRiskManagementAssociationcollectionofratios,aswellasfromDun&Bradstreet,Inc.
Toconstructitsowndebt/equityratiosforcomparison,itwillbefollowingasomewhatdiffer-entcoursefromthatofthecompaniesintheearlierexamples.Insteadofassigningbothliabilities(debt)andassetsexclusivelytoonefieldoranother,itrecognizesthatitsoperationsfrequentlyoverlapseveralfields.Foreachfieldtowhichitwillbecomparingitself,itisaskingwhichofitsassetsandliabilitieswouldbeusedorwouldexistifitwereonlyinthatfield.Severalassetandliabilityitems,therefore,maybeincludedinmorethanonecomparisonandwillnotalwaysbeproportionallydividedamongthesefields.
Whenithascompletedthisexercise,managementhopestofindthatitsdebtburden,inrela-tiontoitsowners’equityinthebusiness,isnoheavierthanwhatisconsideredgenerallyadvis-ableinthemajorservicefieldsinwhichitoperates.Itwillalsoundoubtedlyfind,however,thatcomparedwithaveragecompaniesinsomeofthesefields,itdependssignificantlymore,orless,ondebtfinancing.Ifthereasonsforthesedifferencesseemunreasonableonanalysis,managementintendstoshiftitsbuy-versus-leasedecisionsforthetypesofequipmentinvolved.
AQuestionofPurchasingHave our inventories, compared with sales volume, gotten out of line with those of others in our industry? Which of our products, in these terms, are showing the best and worst records, and why?
Traditionally,managementhasbeenadvisedthat“20percentofyourproductsprobablyaccountfor80percentofyourinventory,”solooktomakethebiggestcutswheremostoftheinventoryoccurs.Inmanycases,thisapproachcanaccomplishmoreharmthangoodandcanhindersalesanddeliveriesofproductsthatareamongthemostprofitable.Atthesametime,itmayoverlookothersituationsthatcollectivelyaccountformuchoftheexcessinventory.
Example:Amanufacturerofalineofpackagedhousewaressawinventoryvaluesonsuc-cessivereportsclimbing,andsuspectedtheyhadgonetoohigh.Acheckofinventoryturnoverratiosinitsindustryconfirmedthissuspicion.Itbegananinvestigationtodiscoverwhyfinishedproductswerepilingup,andhowtocorrectthesituation.Thetaskwasassignedtothesalesman-agerbecausehewasresponsibleforprojectingsalesandrequisitioningoutputfromproduction.
Hisfirststepwastohavetheavailablesalesandinventorydataorganizedonadetailedprod-uctbasissothathecouldcalculateproduct-by-productinventoryturnoverratios.Itthenbecameapparentthatthesuspectedfinishedproductinventoriesaccountedforonlyaminorfractionoftherising inventoryvaluesreportedonthebalancesheet.Furthermore,becauseofdifferencesinproductioncycles,someproductsgeneratedmuchheavierin-processinventoriesthanothers.
Anotherless-expectedfindingwasthatpurchased-materialsstocksforcertainproductswereabigpartofthetotalinventoryproblem.Somespecializedmaterialswereingeneroussupply,althoughtheproductstheywereintendedforwerenolongersalesleadersorwereactuallybeingphasedoutoftheline.Theinventoryproblem,inotherwords,wasnotonlyaproduct-by-productproblem,butonethatneededtacklingonastage-by-stagebasis.
Thesalesmanager’sreportshowedinventoriesoftheappropriatematerialsforeachproduct,work-in-processandfinisheditemsatthecloseofallofthepastfourquarters.Herelatedeachofthesetoproductsalesforeachquarter,toproduceinventoryturnoverratiosineachcalendarquarter. Basedonhisspecificrecommendations,thecompanytookseveralactions:● Forcertainproducts,itsharplyreducedheavyandagingmaterialsstocks.Excessitemswere
designatedforpossibleuseinotherproducts,assubstitutesforspecifiedmaterials.Thosenot
20 / Business Management Daily
absorbedinthiswayweresoldoff,sometimesatagain.Italsomadeadjustmentsinseasonalorderingandotherpurchasingpracticestominimizefuturebuildups.
● Wherein-processinventorieswerehigh,thecompanyreviewedproductionscheduling.Somepracticesthatithadonceadoptedforconvenience,andtoavoidmorecarefulscheduling,werefoundtobecausingasignificanttie-upofexpensiveinventories—partlyfinisheditemswerebeingtemporarilyshuntedaside.Thesales/in-process stockratioswereusedtozeroinonthese.Thenchangesweremadetoschedules,sizeofproductionrunsandotherpracticesthatwereaddingtotheinventoryload.
● Finally,inarelativelyfewcases,stocksofproductsawaitingshipmentwere,indeed,foundtobeexcessive.Bettercoordinationofshort-runsalesprojectionswithproductionordersreducedsomeofthese.Wheretherewerepile-upsinanticipationofseasonalneeds,specialpreseasonofferstodealersnotonlytrimmedstocksbutoftenresultedinanetincreaseinannualsales.
AQuestionofStabilityHow well could your company withstand adversity—a sudden drop in prices or sales, or an increase in costs?
Oneyardstickusedtoanswerthisquestionisthecompany’sbreak-even point.Expressedinsalesvolume,thisisthepointwhereincomefromsalescoverstotalcosts,bothfixedandvariable.Anotherfactorthatmostmanagerswatchforcontinuously,oncethebasicbreakdownhasbeenprepared,isanysignthatfixedcostsarerising.
Yourfirststep,then,istoseparateallcostsofthecompany’soperationsintothoserelativelyindependentoftherateofoperationsandthosethatvarydirectlywiththenumberofunitspro-duced.Touseanobviousillustrationofthefirstgroup,thecostofrentisfixed,regardlessofthenumberofunitsproduced.Ofcourse,eventheso-calledfixedexpensesmayvaryundercondi-tionsofextremechange(thecompanymaydisposeoforsubletpartoftheplantifvolumefallsenough).Forthepurposesofthisroughcalculation,however,wecansafelyignorethepossibleresultsofsuchextremechanges.Bycontrast,directmaterialscostsvaryalmostexactlyinpropor-tiontotherateofproduction.
Youwillrunintosomeproblemsindealingwiththemanycoststhatdonotclearlyfallintoeithercategory—or,morecorrectly,containbothfixedandvariablecosts.Anobviousexampleispowercosts.Thebasicconnectedloadchargemustbeborneregardlessoftheactualoperatingrate.Onceacompanypaystheminimum,itpaysfortheadditionalconsumptionbasedonactualuse.Inthiscase,thetwoelementsmaybeseparatedfairlyeasily;inothers,itwillbemoredifficult.
Toillustrate,herearesomeguidelinesforbreakingdownlaborcostsintofixedandvariablecategories.Ifsalesfalloff,youmaybeabletoreducethenumberofworkersinaspecificopera-tion,butatwhatpointcanyoualsoreducethenumberofsupervisors?Ifyouhaveonlyone,heorsheisarelativelyfixedexpenseaslongasyouhaveevenafewpersonnel.Inthecaseoflaborcosts,youmaybeabletodeterminetheminimumorganizationthatmustberetainedandclassifythisasafixedexpense.
Totakeanothercommonitem,yourwarehousingcostscontainsomefixedelements(theex-penseofspaceandequipment,andatleastsomesupervision)andsomethatarevariable(wagesofworkerswhomaybeshiftedtoanotherpartoftheoperationifthewarehouseworkloadfallsoff).
Tosegregatefixedandvariableelementsofyourcompany’smixedcosts,youwillundoubtedlywanttoconsultyourcompany’saccountant.Askhertotakeeachcostitemforthelastfullyearandroughlyestimatethepercentagethatisfixedorvariablewithinthenormalrangeofopera-tions.Thepercentagesforthreeorfourpreviousyearsandthecurrentyearcanbeestimatedthe
Mastering Business Finance / 21
sameway,orthoseforthelatestfullyearcanbeusedafteradjustingforanymajordifferences(suchasmakingatransitionfrommanualworktotheuseofmachines).
Onceyouhavethisinformation,calculatethebreak-evenpointinthefollowingmannerforasingleyear:Let’ssayyoudeterminethatyourfixedcosts(FC)are$100,000,sincetheydon’tchangethatmuchfromyeartoyear.Becauseyou’retryingtoforecastyourbreak-evenpointforafuturetime,you’renotsureofyourvariablecosts.Historically,however,theyhaverepresentedapproximately80percentofsales(variablecostsdividedbysales).Whatkindofsalesdoyouneedtobreakeven?Yoursetupwouldlooklikethis:
VC=variablecosts(asapercentageofsales) S = total sales you’ll need to break evenFC=fixedcosts P = profit
Yourbreak-evenformulais: P = S – (FC + VC)Therefore,yourformulawouldbe: P = S – ($100,000 + .8 x S)Sinceprofit,orP,is0atthebreak-evenpoint: 0 = S – ($100,000 + .8S), or
S = $100,000 + .8S
SolvingforS: S – .8S = $100,000 .2S = $100,000 S = $500,000
Thismeansyouwouldhavetochalkup$500,000insalesjusttocoveryourtotalcosts.
22 / Business Management Daily
ProfitFromYourBudget
Fewpeopleenjoybudgeting.Ittakestimeandrequiresself-restrainttosticktoit.Nonetheless, there’snobetterwaytokeepacompanyonfinancialtrackthanthroughaproperlymaintained
budgetprogram.Despitethealmostuniversaldistasteforbudgetaryrestraintswithindepartments,rarelyisthereacompanytodaythatoperateswithoutabudget.Thekeytosuccessfulbudgetingistoinvolvemanagersinalldepartmentsandatalllevelsfromthebeginningstages.
TheBudgetingProcessThebudgetingprocessisanattempttoestablishasetofrealisticstandardsfortheoperationofacompany.Initsfinalform,thebudgetwillbeasetofspecificobjectivesfortheyearahead.Al-thoughtheseobjectivesareidentifiedonlyaftercarefulstudy,theyaremerelyforecasts.Recognizethattheoriginalbudgetwillprobablyneedsomerevision.
Theprocessonlybeginswiththeformulationofthebudgetitself.Everybudgetingsystemmustcontainprovisionsnotonlyforactuallypreparingthebudget,butalsoforimplementingasystem,includingcoordination,control,follow-upandmaintenance.
Tobeeffective,abudgetmustbetailoredtothespecificneedsofyourcompany.Mostwell-designedbudgetprogramsshareanumberofcharacteristics,outlinedasfollows:● Clear lines of responsibility.Tosucceed,yourbudgetingteammustbeabletoassigndefinite
responsibilityfortheperformanceofeachunitmeasured.Thepersonassignedthisresponsi-bilitymusthavefullauthoritytoapplythestandardssetdowninthebudget.
● Management support.Anunsupportedbudgetwillalmostsurelyfail.Youroperatingdepart-mentsmustknowthatyouwillusethebudgetasatoolformeasuringtheirperformance.
● Clear-cut reporting procedures.Whenfinished,yourbudgetshouldbeaprojectionofwhatyourfinancialstandardswilllooklikeatsomepointinthefuture.Therefore,themorecloselyyourbudgetsystemfollowsyouraccountingandreportingclassification,thebetteritschancesforsuccess.
● Realistic standards.Don’texpectyourbudgetprogramtoworkmiraclesovernight.Themosteffectiveonessetthestageforachievableincomeandcostimprovementsduringtheyear.Theyaredesignedtofostercontinuousimprovementinoperatingperformance.Thebudgetisjustoneofmanytoolsinthisongoingeffort,butonethatiseffectiveinpointingouttheweakspots.
DevelopingaBudgetSystemThat’sRightforYouTherearethreebasicapproachestobudgeting,eachwithinnumerablevariations.Inthissectionweexaminethestrengthsandweaknessesofeachapproach.
1. Budgeting from the top down:Inasmallelectronicscomponentsmanufacturer,topman-agementwillgeneratetheprimarybudget.Thentheallocationsaresentdowntothevariousdepartmentmanagersfortheirestimatesofexpensesandprofits.
● Strengths:Thisisbyfarthesimplestapproachtobudgeting.Italsoensuresthatmanagement’sgoalsarealwaysreflected.
4
22
Mastering Business Finance / 23
● Weaknesses:Thistypeofbudgetingassumesthatmanagementhastheoperationalknowl-edgenecessarytobudgetforeverypartoftheorganization.Also,thelackofparticipationbyoperatingpersonnelcanleadtoalackofsupportfor,andcommitmentto,thebudget.
➤ Recommendation:Thisapproachisbestsuitedtothesmallerorganization,wherethereisaneasyfamiliaritybetweenstaffandlinefunctions.Inasmallercompany,managementismorelikelytobeawareofoperationalproblemsandcaneasilybringdepartmentheadsintothediscussions.
2. Budgeting from the bottom up:Budgetingbeginsat theoperatinglevelforadiversified,midsizeplasticsmanufacturer.Itgraduallyprogressesupthroughhighermanagementlevelsuntilitreachesthetopechelons.Ateverylevel,personnelwillreviewandreviseit,butonlywithintheconfinesofbroadcorporateobjectivesthataresetdownattheoutset.
● Strengths:This typeofbudgetprovideseveryoperating levelwithagreaterunderstand-ingofthebusiness.Italsoensuresactiveparticipationandgreatercommitmentfromlowermanagementlevels.Everymanagerknowswhatisexpectedintermsofperformanceduringaspecificbudgetaryperiod.
● Weaknesses:Itrequiresalotoftimetomovethroughtheprocessandcompletethenecessaryadministrativeprocedures.Operatingunitswilloftentendtobeveryconservativeinproject-ingrevenuesandoverlyliberalinallocatingcosts.Somemayevenholdbackonperformancetoprotectthemselves.
➤ Recommendation:Thisbudgetsystemisbestsuitedtoamultiproductcompany,wheremanydiverseoperationshavetobeincludedinasinglebudget.Itrequiresalargestaff,sotheapproachmightnotbeeffectiveinasmallcompany.
3. The two-pronged approach:Ahigh-techcompanybasedinNewEnglandusesacombina-tionofthetwomethodsdiscussedabove.Specificobjectivesforfinancialperformanceareestablishedatthecorporatelevel,andthenaresubmittedtooperatingmanagers,whopreparebudgetsbasedonoperating-levelobjectives.Theirbudgetsarethenapproved,disapprovedorrevisedbymanagementandsentbackdownforpossiblefurtheractionbythedepartments.Theprocesscontinuesuntilafinalbudgetisapproved.
● Strengths:Theformalbudgetrepresentsatruemeetingofthemindsbyallpartiesandrequiresparticipationatallmanagementlevels.Theoretically,thisresultsinacommitmenttoagreed-upongoals.
● Weaknesses:Theprocess canbevery time-consuming if topmanagementandoperatingdepartmentscan’tagreeonthebasicobjectives.It’salsobyfarthemostcomplicatedapproach.Schedulesandsurveysareusuallynecessarytosupportdeliberationsatvirtuallyallmanage-mentlevels.
➤ Recommendation:Thisapproachisbestsuitedtoacompanythathasdevelopedacertainamountofsophisticationinpreparingbudgets.Thesizeofthecompanyshouldnotbeanover-whelmingconsideration,butkeepinmindthatpreparingthedatanecessarytobackupthistypeofprogramwillconsumeasignificantnumberofperson-hours.
OrganizingaBudgetTeamOnceyourcompanydecidesonabudgetingsystem,youcanbegintoassembleateamtooverseetheprocess.Notethatwehavenotincludedapermanentbudgetstaffinourdescriptionoforga-nization(see next page),butprefertousethetalentsofmanagementpersonnelalreadyinplacein
24 / Business Management Daily
variousdepartments.Ifyoudecidelaterthatthecompanyneedsapermanentbudgetstaff,youcouldaddoneundertheaegisofthebudgetdirector.
The Budget Committee
Thebudgetcommitteeatoneservicecompanyincludesthepresident,chiefoperatingofficerandseniormanagementfromeachdivision.Theirprincipaltasksaretoappointabudgetchairmanandtooverseetheentirebudgetingprocess.Specificfunctionsinclude:● Resolvingbudgetingconflictsthatmightarisebetweendepartmentsorbetweenthebudget
chairmanandoperatingdepartments.● Reviewingbudgetestimatesandrecommendingchanges,ifnecessary,toappropriatedepart-
mentordivisionheads.● Reviewingperformancereportsandrecommendingactionwhenneeded.● Approvingthebudgetmanual,whichdetailstheadministrativeprocedurestobefollowedin
compilingthebudgetandcontainstheformsandinstructionsnecessarytocompilethedata.
The Budget Chairman
Thebudgetchairmanisresponsibleforcoordinatingthebudgetestimatesdevelopedbythelinedepartments.Heprovidestechnicalassistancetotheoperatingdepartments,whenevernecessary.Otherfunctionsinclude:● Advisingonbudgetarymatterstoboththebudgetcommitteeandthosewhoareresponsible
foroperations.● Recommendingprocedurestobefollowedbythoseresponsibleforeachbudgetcomponent.● Developingtimetablesforeachstageofthebudget.● Compilingforms,schedulesortablesnecessarytocompletethebudget.● Supplyingsupportdata,suchasrevenueorcostanalysis,whichcouldassistoperatingunits.● Recommendingactiontomanagementbasedonbudgetresults.● Analyzingandinterpretingvariancesbetweenbudgetedperformancelevelsandactualresults.
TeamBudgetingAsbusinesshasgrownsteadilymorecomplex,team budgetinghasproventobeavaluabletoolfordrawingthemanagementgrouptogetheranddirectingitseffortstowardcommonobjectives.Usingtheteamapproach,eachmanageriscalledontoplanandbudget—andwillbejudgedonhisperformance—inhisareaofresponsibility.Toparticipateinthisprocess,eachmanagerisgivenaccountingdataaboutpastandcurrentoperations.
Whatarethebenefitsoftheteamapproach?Managersareencouragedtothinkaheadandbepreparedforchangingconditions.Whentheyanticipatedifficultiesorproblems,theycanmoreeasilyavoidorcorrectthem.Theskillsoftheentireorganizationcanbebroughttobearindeter-miningthemostprofitablecoursesofaction.Throughteambudgeting,performancegenerallyimprovesbecausethepeopleresponsibleforattainingcompanyobjectivesshareinsettingthem.Finally,theconversionofeachmanager’splansintodollar-and-centsbudgetsprovidesherwithafinancialblueprintofheroperationsfortheperiodahead.Thisservesasabenchmarkagainstwhichtomeasureamanager’sperformanceandtospottroubleearly.
A limitation of the team approach:InadequateorfaultyplanningistheNo.1reasonwhybudgetsfail.It’snotunusual,forexample,tohavethebudget(1)provideforacostreduction,withnomentionofwho’sgoingtoaccomplishitorhow;or(2)projectasharpboostinsales,withno
Mastering Business Finance / 25
programspellingouthowthiswillbedoneoratwhatcost.Openingupabudgetprocesstokeymanagerscanincreasethepossibilityofthiskindofwishfulthinking.Itwillbeuptothetopexecu-tive,duringhisorherreviewoftheback-upbudgets,totestthesoundnessofunderlyingplans.
ALookatZero-BaseBudgetingAnothercurrentlypopularapproachtobudgetingiszero-basebudgeting.WhenPresidentCarterdecidedin1977thatthegovernmentwouldadoptzero-basebudgeting,theconceptmushroomedovernightfromasubjectprincipallyofconcerntofinancialexecutivesandorganizationalheadsintoamatterofinteresttoallmanagers.
Thenamezero-base budgeting (ZBB)forbusinessesismisleading.Manypeople,recallingthegovernment initiative,believe thatZBB is a tool forfindingandeliminatingunnecessaryfunctions.That’snotthecase.
Thefactis,inanyorganizationmost,ifnotall,ofthefunctionscurrentlyperformedarenec-essarytoitscontinuedoperation.ZBBisusuallyappliedtohelpmanagementdecidewhethereachofthesefunctionswillmakeitsmaximumcontributiontotheoveralleffectivenessoftheorganizationatitspresentlevelofexpenditure,aloweroneorahigherone.Intheprocess,somefunctionsmaybeeliminated,but thathappensunderanykindofbudgetaryreview. Inmanyinstances,ZBB results in theapprovalof sizable increases in funding foractivitieswhere theanticipatedpayoffwarrantsit.
ZBBisdesignedtohelpmanagementrelateexpenditurestotheresultsexpectedtobeachieved.Eachmanagerpresentsseparatebudgetproposalsforeachfunctionoftheunithemanages.Thus,itissimilartotheteambudgetingapproach.Theseparateproposals,calleddecisionpackages,arewhatdifferentiateZBBfromteambudgetingorthemoretraditionaltypeofbudgetingprocess.
Example:Underconventionalline-itembudgeting,apersonnelmanagerwouldspecifyde-partmentalexpendituresforsalaries,supplies,paymentstoemploymentagencies,etc.Topman-agementwouldthenreviewthetotalofthesecosts.UnderZBB,thepersonnelmanagerwouldpresentseparatesetsofdecisionpackagesforeachofthedepartment’sfunctionalactivities,suchasrecruitingandhiring,EEOcomplianceandbenefitsadministration.
IfyourcompanydecidestointroduceZBBandyou,asamanager,areincludedintheprocess,youwillreceiveinstructionsandformsfromhighermanagement.Althoughtheoddsarethatnotwoorganizationswillgoaboutitexactlythesameway,thepatterninmostorganizationswillfollowthesegeneralsteps:
1. Identifying your objectives:ThesecretoflivingsuccessfullywithZBBliesincarefullyandthoughtfullyestablishingobjectives.Yourbestbetistostartfromscratchbysittingdownandmakingtwolists:everythingyourunitmustaccomplish,asmandatedbylaworbyhighermanagement,andeverythingyouwouldliketodoorbelievewouldimprovetheperformanceofyourunit.Thiscouldincludeprojectsthathavebeenshotdowninthepast.Byallmeans,includeyourkeysubordinatesinthethinkingatthisstage.
2. Refining your objectives:Whenyouhavecompletedyourlists,youmayendupwith20,30ormoreitems.Thenextstepistoconsolidatethemundermoregeneralcategories.Example: Amedicalofficer’slistsmightincludeyearlyphysicalsforexecutives,employeehealtheduca-tion,voluntaryexerciseclasses,flushots.Allofthesemightfallintothecategoryofpreventivemedicine.
Ifyouwindupwithsixorfewercategories,you’rereadytogoontothenextstep.(Thenumberofdecisionpackagesamanagercanproposeisgenerallylimited,asapracticalmatter,tofiveorsix.)Ifyouhavemorethansix,you’llprobablyhavetodosomehardthinkingaboutyourpriorities.
26 / Business Management Daily
3. Stating your objectives:Youarenowreadytowriteupyourobjectivesinfinalformforthedecisionpackages.Thisisacriticalstep.Youwanttostate,asclearlyaspossible,thepurposeofyouractivityandtheresultsyouplantoachieveinrelationtoorganizationalgoals.Example: Supposeyouarethemanagerofsecurityforamanufacturingplant.Agoodstatementofob-jectiveswouldbe:“Toprotect—atthelowestpossiblecost—againstlossesduetopilferage,burglary,robbery,vandalismandfire,thuscontributingtoprofit.”Bycontrast,apoorstate-mentwouldbe:“Topatrolthegroundswithguardsanddogs,andmaintainthesecurityofthefenceandguardpoststopreventunauthorizedactivities.”Thatismoreadescriptionofactivitythanastatementofgoals.
4. Supporting your objectives:Onceyouhavedeterminedtheobjectivesforeachpackage,thenextstepistoexplorealternativewaysofreachingthem.Forestablishedactivities,thecurrentmethodisalwaysonealternative.Othersmightbetocontractouttheactivity,eliminateitorcombineitwithanotherone.
Usually,managersareaskedtospecifytwoalternativesthathavebeenconsidered,andexplainbrieflywhytheyarenotrecommended.Sometimesthismayseemlikeameaninglessexercisebecausetheonebestwayisobvioustoyou.Butthepurposeistoensurethatyoudon’tblindyourselftootherpossibilities,andthiscanoftenbehelpful.
5. Allocating costs:Afteryou’veselectedyourpreferredalternativeforeachobjective,youhavetodecidehowmuchshouldbespenttoaccomplishit.Yourstartingpointwillgenerallybeyourcurrentbudgetandcontrollable-costreports.Onepracticalwaytobeginistosetupaworksheetshowinglineitemsdowntheleft-handsideandobjectivesacrossthetop.Thenal-locateyourlineitemsasbestyoucantoeachoftheobjectives.Thisshowsyourcurrentlevelofeffort(spending)andwillbespelledoutinadecisionpackage.
Dependingontherequirementsestablishedbyyourorganization,youwillalsobeexpectedtodefinetwoormorelevelsofeffortinrelationtoeachobjective.Ifthecurrentfundingdoesnotaccomplish100percentoftheobjectiveyouarerecommending,thenoneormoreoftheadditionallevelswillbehigherthanthepresentexpenditure.Youwillalsobeaskedtospelloutsomelevelsbelowthecurrentfundingthatwouldbefeasible,butnotnecessarilydesirable.Oneofthesemaybeaminimumlevel,belowwhichitisnotworthwhiletocontinuethefunction.Manyorganiza-tionssetfiguresinpercentagesforthelowestlevelofeffort.
6. Preparing your decision package:Nowyouarereadytofillouttheformsthatwillbecomeyourdecisionpackages foreachobjective.Mostorganizationsdesign theirown,buteachpackageshouldincludethefollowing:
● Adescriptionofgoalsorobjectivesforeachlevelofeffort(expenditure).● Abriefdescriptionoftheactivitytobeundertakenandthecostsinvolved.● Theexpectedbenefitthislevelofeffortwillprovide.● Theprobableunfavorableconsequencesifthefundingisnotapproved.
Usually,youwillalsobeaskedtonotethealternativesthatyouconsideredbutdidnotulti-matelyrecommend.
Next,youmustrankthecompletedpackagesinorderofimportance.Ifyouhavefiveobjec-tives,youwillhavefivesetsofdecisionpackages,eachofwhichmustberankedagainst theothers.Thenthepackagesaresentontoyoursuperiorortosomeotherdesignatedindividualintheorganization.
Mastering Business Finance / 27
7. Evaluating decision packages: Evaluationproceduresdiffer amongorganizations. Somebusinessesuseagroupsystem.Managersonagivenlevel,workingasarankingcommittee,discussoneanother’sproposalsandrankthembeforesubmittingthemtotheofficerinchargeofZBB.Inothercases,alldecisionpackagesgodirectlytotopmanagement.
Oncemanagementhasdecidedwhichdecisionpackagestoacceptandatwhichlevelofeffort,themanagerisusuallynotifiedbyherimmediatesuperior.Theamountsapprovedthenbecomethelimitswithinwhichthemanagerpreparestheconventionalline-itembudget.Thisisused,asusual,foraccountingpurposesandtomonitorcurrentexpendituresduringtheyear.
WhatNottoExpectFromaBudgetTherearelimitstothebenefitsabudgethastooffer—limitsthatmanagementissometimesslowtorecognize.Herearesometrapstoavoidwhenimplementingorreorganizingyourownbudget,whetheritbeforadepartmentorawholecompany:
✔ No substitute for a cost-reduction program:Atone timemanagementviewed itsbudgetprimarilyasacost-reductiontool.Itprovidedmeaningfulreductionsincostsduringthefirstyearortwoafterinstallation.Afterthefathadbeentrimmed,however,costreductionsbecamemoredifficulttoachievesimplybecausetherewasalimittotheimprovementsanoperatingmanagercouldproducewithoutadditionalmanagementsupport.
Oncethislimithadbeenapproached,furthertighteningofbudgetstandardswasself-defeating.Operatingmanagers,realizingthatthenew,morestringentbudgetstandardscouldnotbemet,simplyignoredthem.Becausemanagementcouldn’tdischargeallthemanagers,varianceswereoverlookedandthebudgetbecameineffective.
➤ Observation:Cost-reductionsystemscostmoney.Whetheritbenewcapitalequipment,moresophisticatedcostaccounting,additionalengineeringsupportorawork-measurementpro-gram,aconcertedprogramtoreducecostsmustinvolvemuchmorethanabudget.Thebudgetingfunctioncanhelpidentifytheseneedsandcanspottheimprovementwhenitcomes.Itcannotdothejobalone,however.
✔ Not written in stone:Allbudgetsshouldbesubjecttoperiodicreviewandrevision.Budgetsshouldneverberegardedasthefinalwordonhowtorunanoperation.Yet,inmanyinstances,operatingmanagersattempttoadheretooutdatedbudgets,eventhoughtheyrecognizethatthebestinterestsofthecompanymightbebetterservedbyabudgetrevision.
Example:Adepartmentheadcomesupwithagoodideathatwillsavemoneyinthelongrunbutwillincreasecostsinthenextfewmonths.Ifyousidetracktheideabecauseofbudget-aryconstraints,yourcompanyneedstoreviseitsconceptofbudgeting.Bythesametoken,anoptimisticproductionplannotquicklyalteredinaneconomicdownturncanplayhavocwiththecompany’sfinances.
✔ No substitute for a long-range plan:Manycompanies,afterinstallingaformalbudget,be-lievetheyhavealsotakencareofanynecessaryplanning.Nothingcouldbefurtherfromthetruth.Corporateplanningisakintobudgetinginmanyrespects,butitisfarafieldinsomeall-importantareas.
First, there is thegoal-setting function.Abudgetusuallyassumes that theoperationsofthecompanywillremainmoreorlessintactforatime.Aplanmakesnosuchassumption.Onthecontrary,oneofthepurposesofplanningistosetnewgoalsformanagement.Second,there
28 / Business Management Daily
aretiming considerations.Byit’sverynature,budgetingisconcernedsolelywithshort-rangedecisions.Budgetsusuallyhavearangeofoneyear,brokendownintoquartersandmonths.Bycontrast,planningplacesprimaryemphasisonthelong-termoutlook.Fiveyearsisusuallytheminimumperiodinvolvedinlong-termplanning.
➤ Observation:Intruth,budgetingandplanningcomplementeachother.Companiesthatfailtotakethetimeandefforttoworkoutlong-termgoalsoftenfindthattheirshort-termobjec-tivesareinconflictandarewastingcorporateassets.Thosewhofailtosetdefiniteshort-termplansmayoftenfindthatlong-rangegoalsareunattainablesimplybecausetheywerebasedonerroneousassumptions.
Mastering Business Finance / 29
ShouldYouUseaFixed orVariableBudget?
Onceyouhavedeterminedyourbudgetingapproachandhaveassignedcertainfunctionsto yourstaff,youcanproceedtothenextstep:developingthebudgetitself.Therearetwo
formatsyoucanuse:fixedorvariable.Eachhasitsstrengthsandweaknesses.Yourdecisiononwhichformtousewill,inthefinalanalysis,dependonwhatyouwantyourbudgettoaccomplish.
Fixedbudgets areby far themost common,particularly in smaller companies.Theyarerelativelysimpletopreparebuthavedefinitelimitations.Variable,orflexible,budgetsrequireabitmoreworktoinstall.Theyare,however,mucheasiertoadjustforinflationandforchangesinthelevelofoperatingactivity.Theemergenceofinflationasarelativelypermanentfixtureonthebusinessscene—anditsconsequentimpactonbusinessactivity—hasinevitablyledtotheincreaseduseofvariable-budgettechniques.
LimitationsofaFixedBudgetInasmallmetalworkingfirmusingafixedbudget,preparationsbeginaboutmidwaythrougheachfiscalyear.Eachdepartment,withthehelpofaccounting,preparesanoperating-costbudget,whichisthensenttoseniormanagement,whomayreviseit.
Ifrevisionisnecessary,theywillholddiscussionsandironouttheirdifferences.Then,nearthebeginningofthenewfiscalyear,thenewbudgetiscirculated,completewithmonthlyactivitygoalsandcostallowancesfortheentireyear.Meanwhile,managementhasusedthebudgettoestablishoverallsalesandprofitprojectionsfortheyear,andhassetcapitalexpendituresaswell.
➤ Observation:Aslongassalesorrevenuestayreasonablyclosetobudgetedlevels,theearn-ingsestimateandcoststandardsshouldholdupfairlywell.However,shouldtheactivitylevelvarytoanysubstantialdegreefromtheoriginalforecast,costallowanceswillquicklygetoutofline.
How Rising Sales Can Affect a Fixed Budget
Youare themanagerofaproductiondepartment foramidsizemanufacturingcompany.Theoriginalbudgetcalledforyourdepartmenttoprocess50,000unitsinNovember.However,becausebusinessactivitypickedup,youactuallyprocessed60,000units.Asaresultoftheextravolume,yourdirectlaborcostsforthemonthrosefromabudgeted$10,000to$11,000.Also,insteadofconsuming$1,500inoperatingsuppliesduringthemonth,yourdepartmentusedup$1,700worthofsupplies.Asthemonthdrewtoaclose,yourbudgetreportwouldlooksomethinglikethis:
Budget Actual Variance
ProductionUnits 50,000 60,000 10,000 DirectLabor $10,000 $11,000 ($1,000) OperatingSupplies $1,500 $1,700 ($200)
Inotherwords,yourdepartmenthashandleda20percentincreaseinvolumewithonlya10percentincreaseintwoimportantexpenseareas—acommendableperformance,byanystandard.Yetthebudgetpersistsinassigningyourdepartmentanunfavorablevarianceof$1,200.Youare,ineffect,beingcensuredforyourefficiency.
5
29
30 / Business Management Daily
How Falling Sales Can Affect a Fixed Budget
Onceagain,assumethatyouarethemanagerofadepartmentforamidsizemanufacturer,withanactivitybudgetof50,000unitsforthemonthandcostallowancesof$10,000and$1,500fordirectlaborandoperatingsupplies,respectively.Thistime,however,youractualvolumeslowsto40,000units,whichresultsina$1,000declineindirectlaborcostsanda$200declineinthecostofoperatingsupplies.Nowyourbudgetwouldbecalculatedlikethis:
Budget Actual Variance
ProductionUnits 50,000 40,000 (10,000) DirectLabor $10,000 $9,000 $1,000 OperatingSupplies $1,500 $1,300 $200
Inthissituation,youroutputhasdeclinedby20percent,butyouhavebeenabletoslicecostsbyonly10percent—notaveryhappysituation.Yet,byusingafixed-budgetsystem,youarecreditedwithafavorablevarianceof$1,200.
Comparing Changes
Obviously,goodmanagersdonotfallvictimtoillogicalconclusionssuchasthosedescribedabove.Theseexamplesdopointout,however,theproblemofattemptingtocontrolcostswhenusingafixedbudget.Evenifthecost-controlmanagerrecognizesasmallerriseincoststhanvolumeincreaseswouldjustifyinyourdepartment,thereisnoattempttomeasureyourefficiency.
➤ Observation:Afixedbudgetprovidesnostandardstousewhenyouaremeasuringcosts.Asaresult,ananalystwindsupattemptingtorelatebudgetedcostsatbudgetedlevelsofactivitywithactualcostsatactuallevelsofactivity.Therelationshipbetweenthetwoistenuousatbest,andthereforeitcansometimesleadtomisinformation.
UsingaVariableBudgetAnintegratedpapermanufacturerwithseveralplantsusesavariablebudget.Itpreparesprospec-tivecostallowancesforarangeofactivitylevels,basedonobservedvariable-costrelationships.Eachplant’scostallowanceisdeterminedonthebasisoftheactuallevelofactivity.Budgetper-formancereportsincludebothactualmoneyspentandthebudgetallowanceforeachcostitem,allattheactualactivitylevel.Thus,managementcancomparebudgetedcostswithactualcosts,bothatactuallevelsofactivity.Moreover,becausecostsareadjustedeachmonth,profitprojec-tionscanbebroughtuptodateandrefined,whichallowsmanagementsufficienttimetotakeanyactionnecessarytokeepoperationsatoptimumlevels.
The Need for Flexibility
Onlyafewfirmsarestableenoughtoallowforaccuratemonthlypredictionsofoperatinglevels.Yearlyforecastsmaycomeclosetoactualsales,butanannualforecastisrarelysufficienttosatisfythemanagerwhomustplanday-to-dayproductionschedules.Tobeeffective,budgetingmustbedoneinmonthlyincrements.Becauseitisnotpossibletopredictexactlywhatdirectionopera-tionswilltakefrommonthtomonth,theonlylogicalansweristobuildsomeflexibilityintothebudgetprogram.
Mastering Business Finance / 31
Budgeting After the Fact
Thekeytoflexiblebudgetingistoestablishbudgetallowancesafterthemonthends.Assoonasyouknowactualactivitylevelsforthemonth,calculateallowancesandsendreportstodepart-mentheads.Makeeveryefforttosendthemoutwithinaweekto10daysafterthemonthends.
Underafixedbudget,youcancirculate theallowance foragivenmonthwellbefore themonthbegins.Asaresult,thedelayinvolvedincirculatingbudgetreportsforavariablesystemhasunderstandablyledtosomeconfusionoveritseffectiveness.Somearguethatifdepartmentheadsarenotinformedoftheirbudgetallowancesbeforethemonthbegins,theycannotbeheldaccountableforkeepingwithinthoseallowances.Whilethisargumentunquestionablyhasmerit,itislessimposinginpracticethanintheory.
Practicallyspeaking,allgooddepartmentheadsareintimatelyfamiliarwiththepaceofac-tivityintheirdepartment.Theyareawareofchangesintheoperatingrateandcanusuallycomeupwithavalidestimateofproductionforthefullmonthafteraweekorsohaselapsed.Theymaybesurprisedbysuddenshiftsinproduction,butmanagementcanavoidproblemsbykeepingoperatingdepartmentsabreastofthelatestproductionforecasts.
Getting What You Pay For
Avariablebudgetwillcostmuchmoretoimplementthanafixedbudget.Costanalysisismoredetailed;theextratimeandeffortthatgointoitwilltakemoney.Onceyouhavegatheredtheinformation,however,thecostofadministeringavariablebudgetwillprobablynotdiffertoomuchfromthatofafixedbudget.Moreover,byusingaflexiblebudget,youwillsetupmoreeffectivebudgetstandards,resultingintightercontroloveroperatingcosts.Generallyspeaking,firmsinstallingavariablebudgetfindthat,onbalance,theysavemoneyunderthenewsystem.
32 / Business Management Daily
ProducinganEffectiveBudget, StepbyStep
Whetheryoudecideon afixedorvariable budget, oruse a teamorbudget committee approach,therearegeneralstepsthatanycompanytakesonthewaytogettingoutthe
budgetdocument,aswewilloutlineinthissection.
Step1:DevelopaSalesForecastOnceyourbudgetorganizationisinplace,theonlyremainingtaskofanyconsequenceistofor-mulateasalesforecast.Thosewhointendtouseabudgetprimarilyasacost-controldevicemightquestiontheneedforafull-blownsalesforecast.Nonetheless,aforecastofsales,brokendownbymonths,canhelpmaintainasmoothproductionscheduleevenifyourcompanydoesnotseetheneedforaconcreteestimateofprofits.Itcanalsohaveabeneficialimpactoninventorycontrolandpurchasingactivities.
Ifyouintendtouseyoursalesforecastforprofitestimatesonly,ageneralforecastwillprobablysuffice.Bycontrast,ifyourcompanyisconsideringamajorcapitalexpansionprogram,orintendstoinvestinlong-termresearchanddevelopment,youmaywanttoadoptamoresophisticatedapproach.Thefollowingisarundownofseveralsalesforecastingmethods:● Sales force survey:Askeachsalespersontoestimate,byproductandcustomers,thesalesin
hisorherterritory.Sometimesestimatesfromthefieldareaugmentedbysupervisoryprojec-tions,andthetwoarethenreconciled.
➤ Observation:Theprimarybenefitsofthisapproachincludeobtainingthelow-cost,activeparticipationofthesalesforceandgettingverydetaileddata.Drawbacksincludepossibleunre-alisticgoalsbythesalesforce,theinabilitytoincludeforecastsforplannednewproducts,andthefactthattheforecastisnotcapableofpointingoutanyturningpointsinthemarket.● Product survey:Anindustrialproductscompanyfirstidentifiesasmanypotentialcustomers
aspossible.Afterthelistiscomplete,prospectsarepolledontheirbuyingplansfortheyear.Finally,resultsofthepollareusedtocompileanindustryforecast.Byapplyingthecompany’santicipatedmarketsharetoeachproduct,itcanderiveaforecastofsales.
➤ Observation:Theproductsurveyishelpfulinbroadeningacompany’slistofcustomersandpotentialcustomers.Inmanyinstances,however,responsestothepollarenotverythought-ful,particularlyfromprospectswhohavenorelationshipwiththeinquiringcompany.Moreover,thetechniqueisexpensiveandusuallyinappropriateforacompanythatservesalargenumberofindustries.● Consensus method:Themanagementofaconsumerproductsmanufacturerselectsanumber
ofexperts,fromboththecompanyandoutsidesources,toprovidesalesforecastsalongwiththeirreasonsfortheforecasts.Acoordinatorsummarizestheindividualforecasts,circulatesthemandschedulesa roundtablediscussionabout them.Sometimes,a second forecast issubmitted.
➤ Observation:Thismethodhasseveralnoteworthydrawbackseventhoughitsolicitsthehelpofoutsidesourcesandcanbeusedtodevelopaconsensusonnewproductsaswellascur-rentlymarketeditems.Itisentirelysubjectivebecausenoquantitativedataareused;itseldomcontainsdetailsonproductlinesorgeographicareas;anditcanbeextremelytime-consuming.
6
32
Mastering Business Finance / 33
● Technical forecasts:Manycompanieskeepmoundsofstatisticaldatagleanedfromrawsalesreports.Thesereportsareoftenusedtosupplement,orevensubstitutefor,theirannualsalesforecasts.Twoofthemorefrequentlyusedtechnicaltoolsaretrend projectionsandmoving averages.
Withtrendprojections,pastsaleshistoryisusedtoestablishatrendlinethroughtheleast-squaresmethod,whichtodayiscarriedoutbycomputers.Thistrendlineisthenextrapolatedandusedasthebasisforasalesforecast.Inthecaseofmovingaverages,anaverageofsalesforaspecificperiodiscompiled.Then,atpredeterminedintervals(usuallyeachmonth),theoldestperiodisdropped,thenewestaddedandanewmovingaveragecalculated.Themonthlyaverageisplottedonacharttoestablishatrend.● Computer-based techniques:Theincreasedavailabilityofcomputersforsmallandmidsize
companieshasspawnedanumberofsophisticatedforecastingtechniques,formerlybeyondthecapabilityofsmallercompanies.Althoughthesetechniquesstillcostmorethanthemeth-odsmentionedearlier,theyarenowwithinthegraspofmostcompanies.
Regression analysisinvolvesaseriesofteststodeterminewhichsocialandeconomicfactorscorrelatewithpastsales.Whenanindexormeasurementthatfitsthesalespatternisfound,itisusedasthebasisforprojection.With econometric modelsaseriesofrelevantregressionfactorsarecombined,andforecastsforthemserveasabasisforthesalesforecast.
Salesforecastsareextremelyimportantinthebudgetprocessbecauseallotheractivitiesaregearedtothesaleslevel.Ifthesalestargetissettoohigh,asurplusincapacity,personnelandinventoriesmayresult.Ifsalestargetsaresettoolow,salesandprofitsmaybelostthroughstock-outs,delayeddeliveriesorinadequatecustomerservice.
Step2:DevelopMeasuresofActivityBeforeattemptingtocategorizecosts,youneedtoworkoutameasureofactivityforeachoperation.Totranslatethesalesforecast(whichusesunitsofproductsold)intoinformationthatwillbeusableforthebudgetanddepartmentheads,findmeasuresofactivity(standardhours,tons,dozens,units,cubicyards,etc.)thatarebroadlyapplicabletoyourcompanyandtoeachdepartment.
Example:Amanufacturingdepartmentcouldmeasureactivityintermsofphysicaloutput(tons,pounds,bushels)ortime(person-hours,actualproductionhours).Aservicecompany,suchasarailroadoranairline,coulduseanumericalmeasurement(numberoftrips,passengermiles,tonmiles).
Justmakesurethatthemeasurementcanbeusedtoidentifysimilarcostsinotherdepart-ments,andthatthemeasureisinfluencedprimarilybyvolume.Themostwidelyusedmeasur-ingrodforcostsiscalledstandard hours produced.Inthiscase,youmultiplythetimestandardforaparticularoperationbythenumberofpiecesproduced.Usuallytheaccountantorfinancialmanagerwillhandletheconversionoftheunitsalesforecastintodollars,basedonguidelinespreviouslyestablishedwithrespecttoprice.
Ifthebudgetistobebasedon“nochangesinprice”or,say,a5percentpriceincreaseonallproductsfortheentireperiod,it’sasimplemathematicalcalculation.If,however,theguidelinescalledforvaryingpricechangesbyproducts—differentincreasesanddecreases—andthechangesareplannedtotakeplaceduringtheperiod,thecalculationswillbeslightlymorecomplex.Thefinancialmanagerwillhavetodeterminewhatpercentageofthesalesfortheperiodareexpectedtotakeplacepriorto,andsubsequentto,thepricechangeforeachproductaffected.Agoodstart-ingpointusuallyispasthistory.
34 / Business Management Daily
Example:IfapriceincreaseisplannedforApril1(inanannualbudget),and25percentofthebusinessonaparticularproductisnormallysecuredinthefirstquarter,thefinancialmanagerwouldconvert25percentoftheunitsattheoldpriceand75percentatthenewprice.Beforetheconversionismade,however,thesalesmanagershouldcheckforanyanticipatedchangesfrompastpatterns.
Beforecomputinggrossmargins—saleslessproductcosts—thefinancialmanagermustbeadvisedoftheanticipatedchangesinproductcosts(materials,laborandfactoryoverhead).Becausethesewillbeeducatedguesses,thechangesareusuallyaveragedandexpressedasapercent-ageincreaseordecreaseincurrentproductcosts.Somefirmsgoastepfurtherandestimatethechangesbymajorelements—forexample,materialsup5percent,laborup7percentandfactoryoverheaddown10percent.
Aftergrossmarginsarecomputed,thefinancialmanagerwillhavethefirstthreeentriesforthepreliminaryprofit-and-lossprojection:sales,costofgoodssoldandgrossmargin.Hewillalsowanttoretainbackupsheetsshowinghowthefigureswereprepared.Insomefirms,thetopexecutivemaywanttoseethesameitemsbyproductlineforcomparativepurposes.
Step3:CollectHistoricalDataCollectinformationonwhatthecompanyhasspentinthepastforallcostaccounts,anddeter-minetowhichdepartmentthesecostshavebeenallocated.Nowisthetimetomakeanychangesinthoseallocations.
Realisticcostallocationisattheheartofanysoundbudget.Withavariablebudget,whichrequiresthesecoststobeidentifiedoverawiderangeofoperatinglevels,thetaskisfarmorecomplicatedandexpensivethanunderafixedbudget.Budgeting,however,isnottheonlyareainwhichmanagementcanusedetailedcostdata.Productpricing,long-rangeplanning,market-ingcampaignsandmanyothercorporateendeavorsdependonproperidentificationofcosts.
Step4:DoCostAnalysisAnalyzeeachcostandcategorizeitasfixed,variableormixed.Eachcategoryisdiscussedhere.● Allocating fixed costs:Essentially,fixedcostsareacompany’soverhead.Theterm“fixed”
doesnotimplythatthesecostsneverchange,merelythattheydonotchangeasthefirm’ssalesactivitymovesupanddown.
Perhapsbecauseoftheuseoftheterm“fixed,”managementisofteninclinedtoacceptfixedcostsasanecessarypartofbusinesslife.Infact,manyfixedcostscan,andshould,bealteredwithchangesintheproductlineorthepurchaseofcapitalequipment.Forinstance,acompanymayreducetheadministrativestaffaftertheadditionoflaborsavingdevices,suchaswordprocessors.Insurancepremiumsareoftenadjusteddownwardafteraninsuranceaudit.Evendepreciation,themostrecognizablefixedcost,changesovertime.
Inotherwords,so-calledfixedcostsarenotfixedatall.Theycangetoutofhandjustasvariablecostsoftendo.Thisisparticularlytrueafteralengthyperiodofhighactivity.Ifyourcost-analysisprogramdoesnothingmorethanpointoutthisfact,itwillbemorethanworththeeffort.
Onceyou’veproperlyidentifiedfixedcosts,however,theanalysisisfairlystraightforward.Essentially, two steps are involved: investigation andallocation. First, investigate thebasicreasonforincurringthecost,andwhatfactorscauseittoriseorfall.Whenyouhaveidentifiedthesetwoingredients,assignthecosttoaproductorproducts.Asanexample,youmightallocateadministrativecostsamongseveralproductlinesbyusingpercentageofsalesvolumeasaguide.
Mastering Business Finance / 35
➤ Caution:Avoidthetemptationtoallocatefixedcostsarbitrarily.Inmanycompanies,fixedcostsarespreadindiscriminatelyamongallproducts.Thisresultsinoneproductbeingcarriedbyanother.Itisthiskindofcorporateinjusticethateffectivebudgetingalwaysseekstouncover.
Second,afteryouhaveinvestigatedafixedcostandcometoadecisionastohowitistobereallocated,bepreparedtodefendyourdecision.Thereassignmentoffixedcostscancauseafurorinmanagementcircles.Productionmanagers,forinstance,willseldomsitbyquietlywhiletheirdepartmentalcostsareraised.Similarly,marketingwillbereluctanttoseeproductcostsraisedtoapointwheretheymightrequirepricechanges.Keepinmind,however,thatabudgetisusefulonlyiftheinformationituncoversisproperlyused.● Controlling variable costs:Avariablecostdirectlydependsontheactivityinvolved.Asthe
activityrisesandfalls,thecostfollows.Iftheactivityceases,nocostisincurred.Examplesofvariableordirectcostswouldincludesalescommissions,directlaborandrawmaterialscosts.
Normally,purevariablecostsrepresentanimportantpartofthetotalcostsofoperatingacompany.Thus,theyarealsoimportanttoaneffectivebudget,eventhoughtheyareusuallyfewinnumber.Becausepurevariablecostsaresoeasilyspottedandaredirectlyrelatedtoaspecificactivity,thereisrarely,ifever,aprobleminproperallocation.Fromabudgetingstandpoint,theprimaryprobleminhandlingvariablecostsisthedevelopmentofaworkablecontrolsystem.
➤ Recommendation:Inmostareas,abudgetis,inandofitself,aneffectivedeviceforcontrol-lingcosts.Withvariablecosts,however,abudgetmustbesupplementedwithlaborandmaterialstandardstobetrulyeffective.Usually,youcandevelopthesestandardsfromhistoricaldataifyourcompanyhasnotsetproductionyardsticks.Pastperformancereportscanbecombinedwithcostinformationtogeneratereasonablebudgetstandards.Usethesestandardstodevelopfairbudgetallowances.● Classifying mixed costs:Relativelyfewcostscanbedescribedaspurelyvariableorfixed.
Mostcostsarecomposedofelementsofboth;someelementsarefixedandothersvarywiththeactivity.
Insomeinstances,companiesassignmixedcoststoeitherthefixedorvariablecategoryforsimplicity.However,whenamixedcostistreatedaspurelyvariable,thebudgetwilltendtoberestrictiveatlowerlevelsofactivityandlooseathigherlevels.Ifamixedcostisregardedasfixed,thereverseistrue:Thebudgetwillbelooseatlowproductionlevelsandtightathigherlevels.
Toresolvethisallocation-of-costproblem,companiesusescatterdiagramstoestimatemixedcosts.Whenalinear mixedcostisinvolved,forinstance,alinedrawnthroughthepointswillslopeupwardandtotheright;thisindicatesthatcostsstartatafixedlevel,thenrisewithactivity.Whenastep mixedcostisinvolved,thescatterdiagramwillindicateasortofstaircasepattern,involvingaseriesoflinesathigherandhigherlevels.Indrawingthelines,the“eyeball”approachistheonlypracticaloneforthestepcosts.Usetheleast-squaresmethodforlinearcosts.
Besidesshowingyoumixed-costrelationships,scatterdiagramsareusedtodemonstratetheimpactofanycost.Theyareparticularlyusefulinidentifyinganoperatingpracticethatneedsimprovement.Furthermore,thegraphicpresentationprovidedbythescatterdiagramishelpfulinbringingapointhometomanagement.
Step5:DetermineBudgetAllowancesForeachcost,determinebudgetallowances,withasetamountbudgetedforeachfixedcost,andactivityrangesestablishedforvariableandmixedcosts.Thisentailssettingupanoverallexpensebudgetforthecompany,aswellasindividualexpensebudgetsfordepartmentsorsectionsofthecompany(see page 36).
36 / Business Management Daily
Expense Budget, Year Ending Dec. 31: ABC Corporation
Full Year 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.
Sales $420,000 $90,000 $120,000 $80,000 $130,000
Less: Fixed Costs Sales Depreciation‑Office $ 1,200 $ 300 $ 300 $ 300 $ 300 Rent‑Office 9,600 2,400 2,400 2,400 2,400 Administrative Salaries $ 20,000 $ 5,000 $ 5,000 $ 5,000 $ 5,000 Insurance 2,200 550 550 550 550 Manufacturing Property Taxes $ 2,600 $ 650 $ 650 $ 650 $ 650 Depreciation‑Plant 3,000 750 750 750 750 Rent‑Plant 5,000 1,250 1,250 1,250 1,250 Salary of Supt. 12,000 3,000 3,000 3,000 3,000 Total Fixed Costs $ 55,600 $ 13,900 $ 13,900 $ 13,900 $ 13,900
Variable Costs Sales Commissions $ 45,000 $ 8,850 $ 13,070 $ 9,125 $ 13,955 Administrative Supplies $ 4,000 $ 820 $ 1,150 $ 795 $ 1,235 Bad Debt Expense 4,200 900 1,200 800 1,300 Manufacturing Direct Material $ 63,000 $ 13,500 $ 18,000 $ 12,000 $ 19,500 Direct Labor 105,000 22,500 30,000 20,000 32,500 Total Variable Costs $ 221,200 $ 46,570 $ 63,420 $ 42,720 $ 68,490
Mixed Costs Sales Advertising $ 8,000 $ 1,500 $ 2,400 $ 1,500 $ 2,600 Telephone 4,000 850 1,100 800 1,250 Other Sales 12,000 2,500 3,200 2,500 3,800 Administrative Telephone $ 2,000 $ 400 $ 550 $ 400 $ 650 Other Admin. 3,800 900 950 900 1,050 Manufacturing Heat & Power $ 15,000 $ 3,000 $ 3,750 $ 3,500 $ 4,750 Factory Supplies 6,600 1,600 1,700 1,550 1,750 Total Mixed Costs $ 51,400 $ 10,750 $ 13,650 $ 11,150 $ 15,850
Net Income From Operations $ 91,800 $ 18,780 $ 29,030 $ 12,230 $ 31,760
Less: Interest Expense 600 300 300
Federal Income Taxes 41,952 8,639 13,216 5,626 14,471
Net Income $ 49,248 $ 10,141 $ 15,514 $ 6,604 $ 16,989
Mastering Business Finance / 37
Allgeneralexpensesofthecompanymustbecovered.Thisisnotaprobleminmostfirmsbecausethemembersofthebudgetingteam,asagroup,areusuallyresponsibleforallexpenses.If,forsomereason,thisisnotthecase—thetopexecutivemaybelievethatoneormoreindividu-alsarenotyetreadytoparticipateinthebudgetingprocess—theexpensesofthatfunctioncanbebudgetedseparatelyorincludedinthetopexecutive’sbudget.
Beforeeachmanagerpreparesanexpensebudget,thecompanyshouldprovidecertainguidelines:● What expenses should be budgeted?Inthepast,itwascommonforcompaniespreparing
budgetstoallocatethefixedexpenses(rent,light,heat,power,etc.)tothevariousindividualunitsonsomebasis,usuallyfloorspaceoccupied.Morerecently,thetrendhasbeenforeachmanagertobudgetonlythoseexpensesoverwhichshehascontrol.Fixedexpensesarethencarriedinthegeneraladministrativebudgetofthetopexecutive.
● What will be the compensation policies?Thesepoliciesmaychangesignificantlyalongwiththegeneraleconomicclimate(inaprofitsqueeze,forexample),theconditionofthelabormarketorthecompany’sprofitoutlook.Itisimportant,therefore,forindividualmanagerstohaveguidelineswithrespecttothepossibilityofacross-the-boardcost-of-livingincreasesorindividualmeritraises,overtimeand,ifapplicable,raisesfornonunionemployeestoadjustforunion-negotiatedwagehikes.
● What will be the company’s general policy on expenses?Ifthecompanyexpectstohavelimitationsonhiring,newprojectsoroverallcost-cuttingprograms,itshouldcommunicatethesetothedepartmentmanagerschargedwithsubmittingexpensebudgets.Ifthetopexecu-tivethinksthatonedepartment’sexpendituresoronespecificexpenseiscurrentlyoutofline,heshouldalsoconveythispointtotheindividualsinvolved.
Step6:ReviewExpenseBudgetsUnlikeotherstepsinthebudgetprocess,thereviewofeachexpensebudgetgenerallytakesplaceinaconfidentialmeetingbetweenthetopexecutiveorbudgetcommitteechairmanandtheresponsiblemanager,ratherthaninafullmeetingofthebudgetingcommitteeorgroup.Itwillbeuptothetopexecutive,however,to(1)makecertainthatanyservicesorprojectsplannedthatimpingeonotherareasofthecompanyarecoordinatedwiththemanager(s)involved,and(2)judgewhetherthelevelofactivityplannedproperlysupportsthecompany’sobjectives.
Fewtopexecutivesneedanyadviceonhowtoproberecommendedexpenditures.Thereare,however, twosituationsthatoccuragainandagaininexpensebudgeting,andeitheronecansubstantiallyreducetheeffectivenessofthebudgetprocess.
Onedangeroussituationariseswhenthebudgetsofallmanagersarenotequally“tight.”Onemanagermayconscientiouslybudgetaprogramdifficulttoachieveattheprice,whiletheothergiveshimselfplentyofleeway.Thisinequitysoonbecomesknownandseriouslyaffectsperformance.Theseconddangerariseswhenthemanagerslearnthatnomatterhowtightthepreliminarybudgetis,cutswillbemade.Suchanautomaticbudget-cuttingpolicyisboundtoboomerangbecausemanagersmaymerelypadtheirbudgetstowindupwiththeamountstheyreallywant.
Step7:EstimateProfitsWithcostallowancesbudgetedforeachdepartment,youcanforecastmonthlyprofitsbysubtract-ingcostsfromrevenueanticipatedinthesalesforecast.Theresultwillbepreliminaryprofitorlossbeforefederaltaxesforthebudgetperiod.
38 / Business Management Daily
Tofacilitateareviewofthepreliminaryprofit-and-lossbudget,thefinancialmanagershouldpreparecertaincomparativedollarfiguresandratios.Thespecificcomparisonschosenwillvaryamongcompanies,buthereareseveralthatareoftenused:● Profitindollarsandnetprofitasapercentageofsalesforthebudgetcomparedwithcurrent
andpriorperiods.(Profitdollarsmaybeupbutrepresentasmallerpartofsales.)● Budgetedexpensefigurescomparedwithactualfiguresforthecurrentandpriorperiods,
showingpercentageincreasesordecreases.Itmaybedesirabletoprovidethesecomparisonsbothbydepartments(sales,financial,etc.)andbyitemofexpense(totalsalaries,travel,tele-phone,etc.).
● Ratiosofbudgetedexpensestosalescomparedwithratiosofactualexpensestosales,forcur-rentandpriorperiods.(Dollarexpensesmaybeupbutdowninproportiontosales.)Again,itmaybedesirabletoprovidetheseratiosbothfordepartmentsandindividualproducts.
● Theincreaseinthetotalnumberofemployeescontemplatedbythebudget.Controlofthenumberofemployees isoftenconsideredthekeytoanycostcontrolbecauseallcostsaredirectlyorindirectlyrelatedtopeople.Thetrendsoveraperiodofyearsshownbytworatioscanbehelpfulinviewingtheoveralleffectivenessoftheorganization:salesperemployeeandprofitperemployee.Inbothcases,thetotalnumberofemployeesisused.
UsingYourBudgetEvenmoderatesuccessinpreparingthebasicprofit-and-lossbudgetwillencouragethebudgetteamorcommitteetobranchoutintootherareas.Theexpensebudget,illustratedinthissection,thenbecomesafirmfoundationonwhichtobuildacashbudget,usedtoestimatetheflowoffunds,andacapitalspendingbudget,usedtocontrolthecapitalspendingactivities.Bothofthesetopicswillbecoveredinlatersections.
RemembertoFollowUpThebudgetingfunctiononlybeginswhenaformalbudgetisinstalledandoperating.Thecompanyneedstofollowuptoensurethatbudgetsareproperlyusedandthatstepsaretakentoimproveefficiencyofoperationswhenthebudgetpointsoutareasforpossibleimprovement.
Theheartofanysoundbudgetfollow-upsystemisthemonthlyperformance report.Issuedforalloperatingdepartments,thisreportdetailsresultsofthemanager’sefforttokeepwithinbudgetallocation.Dataincludedinthereportsvaryfromcompanytocompany,butalmostallreportsincludebudgetallowancesforthemonth;actualmonthlyspending;variance(differencebetweenallowanceandspending)forthemonth,whetherfavorableorunfavorable;andcumula-tivefiguresfortheyearonallowances,expendituresandvariances.
Performancereportsforavariablebudgetarenotissueduntilthemonthisover.Consequently,itisimportanttosendthemtooperatingmanagersassoonaspossible.Otherwise,departmentheadswillregardthereportsasobsoleteandhavinglittlerelationshiptotheproblemsoftheday.Nobudgetperformancereportshouldreachtheoperatingdepartmentlaterthanthe10thofthenextmonth.
RevisingYourBudgetAnybudgetisanunfinisheddocumentbecausecircumstanceschange.Manytimes,thedataonwhichabudgetisbasedareincomplete—andevenwhentheyaresufficient,thehumanelement
Mastering Business Finance / 39
canaffectthem.Whentheeconomyturnsdown,forexample,anoverlyoptimisticbudgetcanquicklydrainacompany’sfinancial resourcesandsometimes lead toacrisisbeforeremedialstepsaretaken.
Youcanimproveyourcompany’sperformancesignificantlybymovingfromastaticbudgettoarolling budgetsystem.Arollingbudgetisperiodicallyadjustedtotheforecast,onthebasisofthelatestdevelopments,ofwhatthescenarioislikelytobeinthefuture.
Mostrollingbudgetsaremadeonacontinuous12-monthbasis,withadjustmentsmadeeachquarter.Forexample,arollingbudgetpreparedinthesecondquarterof2010wouldrunfromJuly1,2010,toJune30,2011.AttheendofSeptember,anotheradjustmentwouldbemade,andthenewbudgetwouldcovertheperiodbeginningOct.1,2010,andendingSept.30,2011.
Therearetwodistinctadvantagestousingarollingbudget:Yourbudgetisareflectionofthemostrecentbusinessdataavailable,andittakesintoaccountthelatestinputfromyoursalesforceandoperatingstaff.
40 / Business Management Daily
ManagingYourCash
Nothingismoreindicativeofthehealthofyourcompanythancashflow.Asthesayinggoes, “Profitsareanopinion,butcashisafact.”Allmanagersareawarethatprofitslendthem-
selvestobeing“managed”duringanyonespecificreportingperiodtoachievedesiredcorporateorshareholderresults.Bycontrast,yourcashflowisanundeniablereality.
Cashmanagementisaneasyconcepttoenvisionifyouthinkaboutyourownpersonalcheck-book.Youhavetoensurethatenoughmoneyhasbeendepositedinthebanktocoverthechecksyouneedtowrite.Youcountonbeingpaidwhatisowedyousothatyoucanpayyourdebts.Thesameistrueofyourcompany—thenumbersarejustbigger.
Therealaim,then,ofcashmanagementistoensurethattherightamountofcashisavailableatalltimestomeetyourcompany’sneedsandobjectives.Withaneffectivecash-managementprogram,yourcompanywillneitherbesurprisedbyadevelopingcashshortagenorfinditselfstuckwithexcesscashthatshouldbeputtowork.
Anegativecashflowisnotnecessarilybadifitisplannedasanopportunitycostdirectedtowardyieldinggreaterbenefitsinaforeseeableperiod.Acashsurplus,bycontrast,cancauseyourcompanyalmostasmanyproblemsasadeficit,eventhoughtheyarelessdire.Acashsurplusrepresentsassetsthataremakingnocontributionwhatsoevertoyourfirm.Eveniftheseassetsareinvestedwiselyinfinancialinvestments,theyieldinmanyinstanceswillfallshortofyourcompany’sreturnoninvestment.Unfortunately,thereislittlethatcanbedonewithshort-termcashsurpluses,excepttoseekoutthebestpossibleyieldsforthem.
Asanonfinancialmanager, your role indeterminingyour company’s cashflowmaybeminimal—butunderstandingitisvital.First,ifyoumanageassetsorhaveaneffectonsalesoroverhead,youprobablyaffectthecompany’scashflow.Ifso,youwilllikelyfacequestionsabout eitherwhatyouexpecttobringin(salesforecasts)orwhatyouexpecttospend(capitalexpen-dituresoroperatingexpenses).Yourunderstandingofcashflowwillenableyoutoanswerthesequestions.
Plus,ifyouintendtoaskforadditionalstaff,resourcesormoneyforaproposedproject,alookatyourcompany’scash-flowanalysiscouldgiveyouammunition.YoumightseethatcashistightinMarch,butasurplusisprojectedinSeptember.AskingformoneyinFebruarywouldnotbeassmartasaskingformoneyinAugust.
MakingCash-FlowDecisionsTounderstandcashmanagement,keepinmindthesetwobasicprinciples:(1)Cashshouldnotflowintoandoutofyourfirmindiscriminately;and(2)gettingahandleonyourcash-flowsitua-tionmustinvolvenotonlyasubtractionofpayablesfromreceivables,butaplanfordealingwiththetimelagbetweenthetwo.Let’slookatthemajordecisionsyouwillhavetomaketoadheretotheseprinciples.● Timing changes:Theeasiestwaytoraiseorloweryourcashflowistochangethetactical
patterninwhichcashnormallyflowsintoandoutofyourfirmoverrelativelyshortperiodsoftime—say,fourtosixmonths.Youcanspeedupcollectionsand/ordelaycashoutflowstoeaseacashdeficit.
Bear inmind,however, thatchanges intimingmerelyaltercash-flowpatternsfor limited
7
40
Mastering Business Finance / 41
periodswithoutchangingtheamount.Theyshouldhavenoimpactonthefutureperformanceofthefirm,oronthefirm’slong-terminvestment,marketingandgrowthgoals.● Policy changes:Changesinpolicyforthesakeofhandlingcash-flowimbalanceshavemuch
longer-termeffectsthantimingchanges.Suchchangesinvolveacommitmenttoalterprevi-ouslyplannedobjectives in costsofoperations;organizationor replacementofplantandequipment;marketingandsales;andinvestmentinnewproductsorservicedevelopment.
Fromanoperationalpointofview,suchpolicydecisionscouldincluderaisingorloweringinventorylevels,oranincreaseordecreaseinresearchanddevelopmentspending.Fromafinancialstandpoint,youcoulddecidetochangeyourpolicyondividendsorcapitalinvestmentprograms.Ofthetwo,dividendpolicyisthemoreflexible.
Policydecisionsthatalterthefuturecourseofyourbusinessshouldnotbemadelightly.Al-thoughreversible,suchdecisionscanproveverycostlyandthereforeshouldbelimitedtothoseareasmostsusceptibletoquickresponse.● Volume changes:Thesechangesarestrictlyoperationalinnatureandalwaysconsistofcut-
backstoreducecashdeficits.Inadditiontoplannedreductionsinsalesand/orproduction,youcouldreducerawmaterialsandwork-in-processinventories.
● Irreversible policy decisions:Inalllikelihood,yourmostdifficultcash-flowdecisionswillinvolvethisarea.Byitsverynature,thistypeofdecisionchangesyourfirminafundamentalway.Irreversibleoperationaldecisions, forexample,almostalwayscenteronthedisposalofassets.Conversely,youmightseektoputsurpluscashtousebyacquiringacompanyoranotherproductline.
Raisingnewcapitalisthemostfamiliarfinancialmethodofhandlingacashdeficit.Equityfinancingispreferredundersuchcircumstancesbecauseitdoesnotaddtoyourfirm’sobliga-tions.Itisnotalwayspossible,however,forafirmwithacashdeficittoselladditionalcommonorpreferredstock.Asaresult,manycompaniesareforcedtoraisenewcapitalviathedebtroute,whichmeansthatfuturecash-flowmanagementmusttakeintoaccounttheneedtomeetdebtobligations.
UsingYourCashBudgetBeforeyoucancometogripswithcash-managementproblems,youmustfirstknowhowmuchcashwillflowintoandoutofyourcompany.Second,youshouldhaveanideaofwhenthesecashinflowsandoutflowswilltakeplace.Aproperlypreparedcashbudgetcanhelpanticipatepossibleproblemsandevensuggestsolutions.
Thecashbudgetisusedprimarilytospotlightperiodsoftoolittleortoomuchcashratherthanforcontinuouscontrol.Theformerisusuallytheproblemforsmallercompanies,andacashbudgetcanbeinvaluable.Bypinpointingprobablecashneedsbyperiodandamount,thecompanyisaffordedthetimeneededtoobtainextrafunds.
Acashbudgetistaken,inlargemeasure,fromanexpensebudget.Itstartswithacashbalancefromtheoldyear.Then,byusingdataobtainedfromtheexpensebudget,itprojectstheactualebbandflowofcashtransactionsfortheperiod.Formostbusinesses,cashinflowswillcomefromthreesources:sales,cashpaymentsreceivedonaccountandloans.Becausesomecustomerswillpurchaseonaccount,thecashbudgetmustreflectthatpaymentwillbemadeatalaterdate.Thisisanimportantfactor:Accountsreceivable,whilevital,arenotcashinhandandcannotbetreatedassuchtorunthebusinesseffectively.
Illustration:Incondensedform,theexpenseandcashbudgetsforABCPublishingCompanyappearonpages42and43.Bothbudgetscontainannualandquarterlyestimates.Notethatthe
42 / Business Management Daily
cashbudgetindicatesthatABCwillneedtoborrowatotalof$40,000inthefirstquarter(primar-ilytopayincometaxes)butwillbeabletopayitback,alongwithotherborrowings,inthethirdquarter.Moreover,ABCshouldbeabletopayahealthy$50,000dividendinthefourthquarterandstillcarryoverareasonablecashbalanceintothecomingyear.
➤ Observation:Forpurposesofillustration,wehaveusedthesamedataforboththeexpenseandcashbudgets.Inpractice,thetwoareusuallysimilarbutcan’tbeexactlyalikebecauseofthetimelagbetweensalesandcollections.Moreover,estimatesforoperatingexpensesinacashbudgetareusuallysomewhatmoreuptodatethanthoseusedforanexpensebudget.
WheretoObtaintheRightCash-FlowInformationAcashbudget cangiveyouvaluable informationonyourprobable cash-flow trendsover a12-monthperiod.However,tobeeffectiveinmanagingyourliquidassetswillrequiremorethanguesstimates.You’llneeddataonhistoricalcash-flowpatternstojudgewhetheryourcashbudgetisrealistic.And,ifyouaretotaketimelyactiontoavertpotentialcash-flowproblems,youmust
Expense Budget: ABC Publishing Company
Full Yr. 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.Sales: $600,000 $80,000 $300,000 $150,000 $70,000
Less: Fixed Costs Sales $ 15,000 $ 3,750 $ 3,750 $ 3,750 $ 3,750 Administrative 28,000 7,000 7,000 7,000 7,000 Manufacturing 35,000 8,750 8,750 8,750 8,750 Total Fixed Costs $ 78,000 $ 19,500 $ 19,500 $ 19,500 $ 19,500
Less: Variable Costs Sales $ 55,000 $ 7,150 $ 27,500 $ 13,750 $ 6,600 Administrative 12,000 1,560 6,000 3,000 1,440 Manufacturing 230,000 29,900 115,000 57,500 27,600 Total Variable Costs $ 297,000 $ 38,610 $ 148,500 $ 74,250 $ 35,640
Less: Mixed Costs Sales $ 34,000 $ 4,300 $ 17,000 $ 8,500 $ 4,200 Administrative 8,000 1,000 4,000 2,000 1,000 Manufacturing 70,000 9,700 35,000 17,500 7,800 Total Mixed Costs $ 112,000 $ 15,000 $ 56,000 $ 28,000 $ 13,000
Income From Operations $ 113,000 $ 6,890 $ 76,000 $ 28,250 $ 1,860
Less: Interest Expense 2,000 — 1,000 — 1,000 Federal Inc. Taxes $ 47,460 $ 6,170 $ 23,730 $ 11,865 $ 5,695
Net Income $ 63,540 $ 720 $ 51,270 $ 16,385 ($ 4,835)
Mastering Business Finance / 43
Cash Budget: ABC Publishing Company
Full Year 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.
Beginning Cash Balance: $ 16,000 $ 16,000 $ 11,430 $ 86,430 $ 63,880 Collections 600,000 80,000 300,000 150,000 70,000 Total Available Cash $ 616,000 $ 96,000 $ 311,430 $ 236,430 $ 133,880
Less: Cash Payments Sales $ 104,000 $ 15,200 $ 48,250 $ 26,000 $ 14,550 Administration 48,000 9,560 17,000 12,000 9,440 Manufacturing 335,000 48,350 158,750 83,750 44,150 Total Operating Expense $ 487,000 $ 73,110 $ 224,000 $ 121,750 $ 68,140
Interest Expense 4,800 — 1,000 2,800 1,000
Federal Income Tax 47,460 47,460 — — — Dividends 50,000 — — — 50,000 Bank Loan Payment 52,000 4,000 — 48,000 —
Cash Balance (Deficit) (25,260 ) (28,570 ) 86,430 63,880 14,740
Bank Borrowing 40,000 40,000 — — —
Ending Cash Balance $ 14,740 $ 11,430 $ 86,430 $ 63,880 $ 14,740
haveinformationoncurrentcashmovements.Finally,youwillneedtotakealookatfuturecashflowtoestablishanappropriatepolicy.
Althoughcashflow is simple in concept, inpractice it canbedifficult tonaildown.Theprimaryproblemisthatnotwofirmshaveexactlythesamecash-flowpattern.Firmshavedif-ferentcriticalfactorsthatmustbemonitoredandcontrolled.Therefore,everyfirmhasdifferentinformationneeds,requiringthattheinformation-gatheringnetworkbespecificallytailoredtoitspreciseneeds.Thisdoesnotmeanyoumustinventamethodologyforgatheringandanalyzingcash-flowinformation.Themethodologyalreadyexists.Wewilldiscusstwobroadapproachesthatprovideyouwithinsightsforyourfirmfromtwopointsofview.
Receipts and Disbursements Analysis
Thisistheoldest,mostcommonmethodofmeasuringcashflow.Becauseitisbasedoninformationrecordedinthereceiptsanddisbursementslog—abasicbookkeepingledgercommontovirtuallyallfirms—theinformationitselfiseasytoobtainandorganize.
Mostfirmswillcomeupwithrelativelyfewgeneralheadingsfortheirreceiptsandpayments.Thoseheadingsusuallywillfallintothefollowingcategories:
Receipts:Thereareonlyalimitednumberofwaysfortheaveragecompanytoobtaincash.However,itisimportanttodifferentiateeachofthoseinthereceiptsectionofyouranalysis.Onlyifeachcategoryisproperlyidentifiedcanyouproperlymonitoryourcashreceipts:
44 / Business Management Daily
● Collections. Thesearefundsreceivedfromyouraccountsreceivable.Normally,thiscategorywillrepresentthebulkofyourcashinflow.
● Cash sales,orsalesnotinvolvingcredit.Theseareusuallythenextlargestcategorybutstandfarbelowcollectionsinmostcompanies.
● Nonoperating income.Manycompaniesroutinelytakeinincomefromsourcesnotnecessar-ilyassociatedwiththeirprimarybusiness.Thistypeofincomeincludesdividendorinterestincomefrominvestments,rentalorleaseincome,royalties,etc.
● Special, nonrecurrent sources of income.Themostcommonitemsinthiscategoryarenewfinancings(eitherinvestmentsorsurplusfixedassets).However,youcouldincludeincomefromanyunusualsourceinthiscategory.
Disbursements:Thereareanumberofpaymentcategoriesthatafirmcanchoosetoidentifyinitsanalysisofcashflow.Herearesomecommonheadingsthatyoumightconsider:● Supplier paymentsusuallyheadthelistandcanconsistofcashpaymentsaswellasareduc-
tioninaccountspayable.● Wages and salariesaredifficulttocontrolovertheshorttermbutcanusuallybemanaged
overaperiodoftime.● Overhead items,suchasheat,power,telephoneandotherutilities,propertytaxesorrent,are
generallyfixedandbeyondmanagement’scontrol.Thus,youcanusuallybringtheseitemstogetherinonecategory.
● Federal income taxescanchangerapidlyandshouldbeclassifiedseparately.● Recurrent payments,suchasinterestonlong-termbondsordividendpayments,shouldbe
groupedtogetherunderaseparateheading.● Irregular or special financial obligations, suchas short-term loan repaymentsor special
dividends,shouldalsobeclassifiedinaseparatecategory.● Capital expenditures cansometimesbesignificantand,atother times,canamount tono
morethananominalinfluenceonyourcashpayments.However,theyshouldbeclassifiedseparatelywheneverpossible.
● A special miscellaneous categoryshouldbeincludedforextraordinaryitems(suchasthesettlementofalawsuitorapatentpurchase)oranyothersignificant,nonrecurringitem.
Illustration:Tocarryonwithourprevious illustrations,wehavecompiledananalysisofreceiptsanddisbursementsfortheABCPublishingCompanyforthefirstquarteroftheyearbyusingdatacontainedinthecashandexpensebudgetsforthatfirm.Notethatthefiguresfortheactualcashflowareconsistent,eventhoughtheclassificationsusedhavebeenrearrangedtosuittheformatforareceiptsanddisbursementsanalysis.
Wehaveconfinedouranalysistoasinglequarter,brokendownintomonths.Thereisnoneedforyou,however,tofocusonlyononequarteratatime.Iftheseasonalpatternsforyourcompanywarrant,youmightchoosetoconsolidatethedatasemiannually,orevenannually.
Buttokeepyouranalysisuptodate,youwillneedtocompileanewoneeachmonth.Astheanalysisonpage45shows,therewasawarningasearlyasJanuarythatcashflowwouldprobablynotbesufficienttocoverincometaxespayableattheendofMarch.
BytheendofFebruary,theevidencewasconclusive.However,withthewarning,ABCwasabletonegotiateashort-termloanthattookcareoftheincometaxpaymentandamodestdebtrepaymentaswell.
Mastering Business Finance / 45
Receipts and Disbursements Analysis: ABC Publishing Company
1st Qtr. January February March
Receipts Collections $ 62,000 $ 17,000 $ 25,000 $ 20,000 Cash Sales 18,000 4,000 5,000 9,000 Miscellaneous — — — — Bank Loan 40,000 — — 40,000 Total Receipts $ 120,000 $ 21,000 $ 30,000 $ 69,000
Payments Suppliers $ 16,610 $ 3,305 $ 5,105 $ 8,200 Wage & Salaries 34,500 10,500 11,000 13,000 Overhead 22,000 7,000 8,000 7,000 Taxes 47,460 — — 47,460 Interest & Dividends — — — — Debt Repayment 4,000 — — 4,000 Special Items — — — — Total Payments $ 124,570 $ 20,805 $ 24,105 $ 79,660
Current Surplus (Deficit) ( 4,570) 195 5,895 ( 10,660)
Cash Bal.— Beginning of Period 16,000 16,000 16,195 22,090
Cash Bal.—End of Period $ 11,430 $ 16,195 $ 22,090 $ 11,430
Flow of Funds Analysis
Analyzingyour cashflowby theflow-of-fundsmethod ismarkedlydifferent fromusing thereceipts-and-disbursementsmethod.Inthelattermethod,informationisorganizedbyaccount,butinformationinaflow-of-fundsanalysisisorganizedalongthelinesofmanagementresponsibility.Asaresult,itwillpointtothemanagementdecisionareasthatwillbeinvolvedinresolvinganycash-flowproblemsthatmayoccur.
Cash inflows:Whenviewedalongthelinesofmanagementresponsibility,cashcanflowintoyourcompanyinoneofthreeways.First,youcanreceiveincomefromyouroperations.Next,youcanreceiveincomefromafinancing,whetheritbebankloans,yourcreditlinesorthesaleofstock.Finally,youcanconvertapartofyourassetsintocash.Thiscanbedonebytheactualsaleofafixedasset,suchasland,abuildingormachinery,orbyspeedingupcollectionofaccountsreceivableorsellingoffinventories.
Cash outflows:Aswithcashinflow,cashcanflowoutofyourfirminoneofthreewayswhenviewedalongamanagementresponsibilityline.First,therearenormallyrecurringpayments,suchasthosefortaxes,interestpaymentsanddividends.Second,financingobligationsmayincludealoanrepayment,bondredemptionorperhapsareductioninyourlineofcreditwithsuppliers.Finally,youmaydecidetoincreaseyourassets.Youcoulddothisbypurchasingafixedassetorbyallowingcurrentassets,suchasaccountsreceivableorinventories,torise.
46 / Business Management Daily
Flow of Funds Analysis: ABC Publishing Company
1st Qtr. January February March
Cash Inflows Income From Operations $ 6,890 $ 195 $ 5,895 $ 800
Financing Bank Financing 40,000 — — 40,000 New Supplier Credit 10,000 — 10,000 —
Disposal of Assets Fixed Assets — — — — Current Assets — — — — Inventories 2,000 2,000 — — Accounts Receivable — — — — Total Cash Flow $ 58,890 $ 2,195 $ 15,895 $ 40,800
Cash Outflows Recurring Payments Taxes $ 47,460 — — 47,460 Dividends — — — — Interest — — — — Financing Loan Repayment 4,000 — — 4,000 Reduced Supplier Credit — — — — Acquisition of Assets Fixed Assets 10,000 — 10,000 — Current Assets — — — — Inventories — — — — Accounts Receivable 2,000 — 2,000 — Total Cash Outflows $ 63,460 $ 0 $ 12,000 $ 51,460
Current Surplus (Deficit) ( 4,570) 2,195 3,895 (10,660)
Cash Bal.—Beginning of Period 16,000 16,000 18,195 22,090
Cash Bal.—End of Period $ 11,430 $ 18,195 $ 22,090 $ 11,430
Illustration:Toturnonceagaintoourpreviousexample,youwillfindbelowaflow-of-fundsanalysiscoveringthefirstquarteroftheyearforABCPublishing.Fordemonstrationpurposes,wehaveassumedthatduringthequarter,ABCreduceditsinventoriesby$2,000,increaseditsaccountsreceivablebythesameamountandboughta$10,000book-bindingmachineoncredit.
Mastering Business Finance / 47
Onceagain,notehowtheendresultjibeswithboththereceipts-and-disbursementsanalysisandthecashbudgetforABC,eventhoughtheinformationprovidedbythisanalysisisentirelydifferent.Thecashflowisthesame,nomatterhowitispresented,butthereareanumberofwaysoflookingatit.
Evenacursoryglanceattheflow-of-fundsanalysiswillshowthatadditionalfinancingwasnecessarytopaytheMarchtaxbill.Atthesametime,anumberofotherpointsbecomeapparentaswell.First,theseasonalpatternofABC’soperationdoesnothelpthecompany.Eventhoughcashoutlayswerekepttoanabsoluteminimuminthefirsttwomonths,themodestcashbuildupwasoverwhelmedbyout-of-pocketexpensesinMarch.Moreover,eventhoughtheslackFebruaryperiodwasthepropertimetopurchasenewequipment,ABCwouldhavebeenhard-pressedtocomeupwiththeextracashifcredithadnotbeenavailable.
Alsonotethattheflow-of-fundsanalysisdoesnotgivespecificsonwheretheactualcashisbeingspent,justasthereceipts-and-disbursementsanalysismakesnomentionofmanagementdecisionareas.Thus,whileeachmethodhasblindspots,togethertheycanprovideyouwiththeinformationyouneedtomaketimelydecisions.
ForecastingYourCashFlowEitherorbothmethodsofcash-flowanalysiswillgoalongwaytowardsatisfyingyourcash-flowinformationneeds.Becausebotharecompiledonamonthlybasis,youshouldbeabletotrackcur-rentcash-flowpatternsquiteeasily.Inaddition,thequarterlyconsolidationsshouldprovidethedatanecessarytodeterminewhethertheassumptionscontainedinyourcashbudgetwererealistic.
Thisleavesoneimportantareatobeaddressed:theformidabletaskofforecastingcashflow.Withcashflowbeingvital to thecontinuedexistenceofyourorganization, it isessential thatyouattempttopredictfuturecashpatterns,ifonlyasaprecautionagainstapossibleseverecashsqueezesomewheredowntheroad.However,thereareotherbenefitsaswell.
Frequently,acash-flowforecastwillhelpyouavoidacostlybusinessmistake,oritwillprovideanearlywarningsignindicatingthepathtoimprovedmanagementcontrol.Itcanalsorevealtheneedtoraisesignificantfundsbeforeacrisis,oritcanpointthewaytowardproperutilizationofanimpendingsurplus.Evenwiththeseadvantages,cash-flowforecastscancauseproblemsunlesstheyareviewedinthepropercontext.Herearesomekeypoints:● Completely accurate forecasts are impossible.Nomatterhowmuch timeandattention
youdevotetoyourcash-flowforecast,itwillprobablybewideofthemark.Nevertheless,ifproperlyprepared,aforecastcanstillyieldvaluableinformationbyindicatingwhattypeofactionyoushouldtaketoavoidcash-flowproblems.
● Forecasts must establish timing.Notonlymustyouattempttopredicthowmuchcashwillflowintoandoutofyourfirminthefuture,butalsoyoumustforecastwhentheseflowswilloccur.
● Multiple forecasts should be used.Obviously,itwouldbedifficulttodevelopaformatthatcouldmakerealisticforecastsoftheextentandtimingofcashflowsfrom,say,onemonthtofiveyearsinthefuture.Indeed,evenifsuchaforecastdidexist,youmightnotfinditallthatuseful.Inashort-termforecast,youwouldprobablywanttoemphasizethedetailsofcashflowsintoandoutofyourcompany.Thelonger-termforecastwouldplacetheemphasisonthefinancialaspectofyourstrategicplanningeffort.Forthisreason,yourcash-flowinforma-tionneedswillbebestsatisfiedbydividingyourforecastintoseparateareas,onedirectedattheshorttermandtheotheratidentifyinglong-termtrends.
48 / Business Management Daily
PreparingaShort-TermCash-FlowForecastShort-termcash-flowforecastsaredesignedtopredictyourcompany’scashflowforperiodsuptoayear.Initsfinalform,yourforecastwill lookmuchlikeyourreceipts-and-disbursementsanalysis.Aswiththatearlierexercise,theamountofdetailyouincludeintheforecastsisuptoyouandwilllargelydependonyourindustryandyourowninformationrequirements.Undermostconditions,however,arelativelyshortlistofheadings,coveringprimarilythoseitemsthataresubjecttomanagementcontrol,willdo.
Thebestwaytoprepareshort-termcashforecastsisonarollingmonthlybasis—thatis,thefirstforecastoftheyearcoversJanuarytoDecember;thenext,FebruarytothefollowingJanu-ary;thenext,MarchthroughthefollowingFebruaryandsoon.Inthatway,youwillreceivetheearliestpossiblewarningofacashemergency.
Role of Cash-Flow Assumptions
Thefirststepinpreparingyourforecastistotakeacloselookatyourcash-flowperformancefortherecentpast.Areviewofthepastseveralmonthscanbemosthelpfulinprovidinginformationonitemssuchasinventorylevelsandaccountsreceivable.
Next,youmustmakeseveralbroadassumptionsaboutyourbusinessforthenextyear.Isitlikelytobeagoodyear,amediocreyearorabadone?Willcostsriseatafasterratethansales,orviceversa?Manytimesyourassumptionswillbewrong,andyourforecastwillsufferasaresult.However,ifyousetyourassumptionsdownandmonitorthemcontinually,youwillknowwhentheyhavefallenshortofthemark.Asaresult,youwillbepreparedtochangeyourforecastaseventsunfold.
Onceyouhavemadethenecessarypreparations,youcanbegintheactualforecastingproce-dure.Asanillustration,referbacktothereceipts-and-disbursementsanalysisforABCPublishing. Thelineitemsonashort-termcash-flowforecastforthiscompanywould,inalllikelihood,beunchangedfromthereceipts-and-disbursementsanalysis.Theprojectionperiodwould,however,extendforanentireyearonamonthlybasis,ratherthanoverthethreemonthsshownintheanalysis.Here,onaline-by-linebasis,ishowyoumakeyourshort-termcash-flowprojections:● Collections.Thisisbyfarthemostdifficultitemintheforecastandunquestionablyoneof
themostcritical.Keepinmindthatyourprojectionsfortheearliestoneortwomonthsoftheforecastarelikelytobethemostaccurate;youhaveyourrecentsalesresultsandcurrentaccounts-receivableinformationalreadyonhand.
Afterthefirstmonthortwo,yourcashbudgetandpastcollectionexperiencewillbeyourprimaryforecastingtools.Whateverthecase,ifyoubringyourforecastuptodateonamonthlybasis,youwillalwayshavetimetorefineyourearlyestimates.● Cash sales.Yoursalesforecastandpastexperienceareyourprimaryguideswiththiscategory.
Althoughcashsalesarenotmucheasiertopredictthancollections,theyareusuallynotaslargeand,therefore,notascriticaltotheforecast.
● Miscellaneous receipts.Recurringitems,suchasrents,interestanddividends,aresimplemattersoffact.Nonrecurringitems,suchasbankloans,arealmostalwaysknowntomanage-mentinadvance.
● Suppliers.Nexttocollections,thisitemwillprobablyrequirethemostinvestigation.Youwilluseprimarilyyoursalesforecastandinventorypolicytodeterminesupplierpayments,but
Mastering Business Finance / 49
willalsofactorinproductionscheduling,purchasingandyouraccounts-payablepolicy.Yourforecastsforthefirstfewmonthswillbemorereliablethanthoseforthefuture.
● Wages and salaries.This itemisusuallypredictable.Thecostsofovertimeandpart-timeworkersofferthemostsurprises.
● Overhead.Mostoftheitemsarepayableonaregularbasis,sothereshouldbelittledifficultyinmakingaforecastforthiscategory,providedthatyouremembertotakepriceincreasesintoconsideration.
● Financial obligations.Theseincludeinterest,dividends,taxesanddebtrepayment.Again,recurringitemsareknowntomanagement,andnonrecurringitemsaremattersofmanage-mentdecision.
● Special items.Thiscategoryisreservedforone-timedecisions,suchasthesaleofanasset.Allsuchmattersinvolveamanagementdecisionandarethereforepredictable.
UsingaLong-TermCash-FlowForecastThereisafundamentaldifferencebetweenlong-termandshort-termforecasts.Short-termfore-castsare tacticalandconcernedwithmanagementcontrolofanexistingsituation.Long-termforecastsarestrategicanddesignedtoassistindevelopmentoflong-termfinancingplansthatwillmeetmanagementgoals.Asaresult,forecastingyourcash-flowneedsforthelongtermiscloselyrelatedtostrategicplanning.Justasitwouldbefoolishtoforecastfuturecashneedsintheabsenceofspecificgoals,itwouldbefruitlesstoplanacourseofactionwithoutprovidingenoughcashtogetthere.
Ingeneral,yourlong-termcashforecastshouldmirroryourcompany’splanninghorizon.Alwayskeepinmindthatthefartherouttheplanextends,thelessreliabletheforecastislikelytobe.Inouropinion,itisnotpossibletoproduceadetailedfinancialplanforaperiodlongerthanthreeyears.Financialmarketsaretoochangeabletoallowseriousplanningbeyondthat.
Adapt Flow-of-Funds Analysis
Just as the receipts-and-disbursementsanalysisprovideda framework for a short-termcashforecast,theflow-of-fundsanalysistechniquecanbeadaptedtolong-termforecasting.However,unliketheshort-termforecast,somechangesintheformatusedfortheflow-of-fundsanalysisarenecessarytoseparatetheimpactofoperationalandfinancialdecisions.
Illustration:Takealookatthetableonpage50,wherewehaveusedtheinformationcontainedinthecashbudgetforABCPublishingCompanyasthebasisforalong-termcashforecast.Wehavealsoassumedthat,asintheflow-of-fundsanalysis,ABCPublishingdecreasedinventoriesby$2,000andraisedaccountsreceivablebythesameamount.Inaddition,thecompanypurchasedabindingmachinefor$10,000oncredit.
Obviously,thisforecastisbehindthetimes.Intherealworld,theforecastcouldhavebeenmadewellbeforeacashbudgetwassubmittedandwouldextendoutforthreeyearsormore.Nevertheless, itdoesdemonstratehowcloselya long-term forecastparallels aflow-of-fundsanalysis,whileatthesametimeaddinginformationthatlong-termplannerswouldneedtomakeintelligentdecisions.
InABC’scase,nofinancialsurprisesareinstore.Operatingcashmakesupmorethanhalfofthecashneededtomeetobligations.Thebalanceoftheneededcashiseasilymetbyashort-termloanandnewcredit.
50 / Business Management Daily
Normally, long-term cash fore-casts areupdatedannually asman-agementreviewsstrategicplansanddrawsup newbudgets. Therefore,eveniftheplanwereabitwideofthemark,ABCwouldhavetimetoreviseitinsubsequentyears.Rememberthatthefirstyearofalong-termplanmustalwaysconformtoforecastsmadeintheshort-termplan.Otherwise,man-agersmayfind themselves at crosspurposeswithoneanother.
Followingarethemajorcategoriesofinformationinalong-termforecast:● Cash flow from operations.This
category isusuallypart of yourstrategicplan.As cashflow, thisitemisbefore interest, taxesanddepreciation.
● Taxes.Thisisafairlystraightfor-ward item, but don’t overlookpossibletaxsavingsinthefuture.
● Fixed assets (land, buildings, plant and equipment).Paymentsdue for thepurchaseofnewas-setsareusuallyfoundinthecom-pany’scapitalbudget.Don’tforgetthevariouscostsassociatedwiththeseassets,suchasmaintenanceandroutineadministrativeactivi-ties.
● Noncash current assets. Theseincludeinventoriesandaccountsreceivable. Inventory and creditpoliciesdonotchangeoften,soyoucanusuallyapplypastexperiencetosalesprojections for futureyears toobtain reasonable estimates for changes in inventoryand/oraccountsreceivable.
● Financial obligations (interest, div idends, repayment of loans or bonds).Itshouldbesimpletoforecastpaymentsdueoncurrentobligations,butyoumayfinditdifficulttoprojectinter-estandprincipalpaymentsonfutureloans.Dividendsarenotmandatory,butforthesakeofclarity,youshouldincludethem.
● Net cash requirements.Ifthereistobeacashsurplusinyourfirm’sfuture,youwillfirstidentifyithere.Ratherthananetcashrequirement,youwillcomeupwithanetsurplus.Youcan,ofcourse,makeplanstoincreaseyourdividendsortoinvestthesurplusforawhile.
● Available cash.Thisreflectsdrawingsfrombothexistingcashbalancesandcashequivalents(U.S.Treasurybills,certificatesofdeposit,etc.).Asurplustobeinvestedwouldbetreatedasanegativeitemonthisline.
Long‑Term Cash Forecast: ABC Publishing Company
Cash Resources Cash From Operations $ 113,000 Less: Taxes 47,460 Internal Cash Flow $ 65,540
Decrease (Increase) in Assets Land & Buildings — Plant & Equipment (10,000 ) Inventories 2,000 Accounts Receivable ( 2,000 ) Net Asset Change (10,000 )
Net Operating Cash $ 55,540
Financial Obligations Interest $ 4,800 Dividends 50,000 Loan Repayment 52,000 Total Obligations $ 106,800
Net Cash Requirements $ 51,260
Planned Financing From Available Cash $ 1,260 New Credit 10,000 New Borrowing: Short‑Term 40,000 Long‑Term — New Equity Capital — Total Financing $ 51,260
Mastering Business Finance / 51
● New credit.Plannedpurchases,suchasthe$10,000bindingmachinecitedintheillustration,arerathereasytoidentify.However,youmayhavetolookcloselytospotapossibleneedforadditionalextensionsofcreditwithsuppliers.
● New sources of capital.Thesefinalitemsarestrictlytheresultofmanagementdecisions.Theyarethe“balancingitems”butalsorepresenttheendresultofyourfirm’sfinancialstrategy.
KeepingCashFlowUnderControlAsyoucompileyourcashforecasts,betheyshortorlongterminnature,youareforcedtocometogripswithpossiblecash-flowproblems.Nosensibleforecastwouldleaveapotentiallyharmfulcash-flowproblemuntouched.Youranalysesofreceiptsanddisbursementsandoftheflowoffundswillallowyoutomakeanynecessaryadjustmentstobringtheforecastsinlinewithreality.
Thefinalinformationtoolinthesystemisamonthlyliquidityreport,whichiseasilypreparedfrommonthlystatementsandpreviousforecasts.Itgivesyoutheinformationnecessarytomakeday-to-dayworkingdecisionsconcerningyourcashflow.
Illustration:Preparingaliquidityreportismoreamatteroforganizingyourexistinginforma-tionratherthangatheringnewdata.Alltheinformationneededforthereportshouldbereadilyavailableshortlyaftertheendofeachmonth.Fordetailsonhowyourliquidityreportmightlook,seetheboxbelow.
The Cash-Flow Statement
Anotherwaytokeepyourcashflowundercontrolistomonitoritcorrectly.Butbesuretousetherightcash-flowyardsticks.Becauseitcanbedifficulttoderivecash-flowinformationfromtheusualfinancialstatements,manymanagersgaugetheircashfloweitherbyaddingdepreciationbackintonetincomeorbyusingworkingcapitalfromoperationsasasubstitute.Bothmeasures,however,areoftenatoddswithactualcash-flowperformanceandcangiveoffconfusing,orevenmisleading,signals.
Liquidity Report
Current Month Percent Forecast Balance—End of Month Forecast Actual Change Coming Month
Cash on Hand and in Bank _______ _______ _______ _________
Cash Equivalents
(Short‑Term Investments) _______ _______ _______ _________
Accounts Receivable _______ _______ _______ _________
Accounts Payable _______ _______ _______ _________
Inventories _______ _______ _______ _________
Unused Lines of Credit _______ _______ _______ _________
52 / Business Management Daily
● Net income plus depreciation:Eventhoughmanyfinancialprosdousethisformula(cashflow=netincome+depreciation)todefinecashflow,it’snotentirelyaccurate.Theformularepresentsmoreameasurementofprofitability,orwhatsomebusinessresearcherscallgrosscashflow,thannetcashflow.Forexample,it’saparadoxofbusinessthatcompanieswithlittleornogrowthusuallyhavefewercashproblemsthanhigh-profit,rapid-growthfirms.
● Working capital from operations:Again,someusetheworkingcapitalformula(currentassets–currentliabilities=workingcapital)tomeasurecashflow.Eventhoughworkingcapitalisexpressedindollars,itcan’tbespentlikecash.Workingcapitalisaconceptthatdoesn’tpayday-to-daybills;onlycashdoes.
Flow-of-Funds Statement
Acash-basispresentationinyourflow-of-fundsstatementavoidsthepotentialproblemsofrelyingtooheavilyonworkingcapitaltrendswhile,atthesametime,quicklygivesyouaclearpictureofyourcompany’soverallliquidity.Theflow-of-fundsorcash-flowstatementcanbestructuredanumberofways—noneofthemcomplicated—toreflectchangesinyourcashposition.
Tobeuseful,yourflow-of-fundsstatementshouldtellyouwhetheryouroperationsaregen-eratingenoughcashtosupportexpenditures.Specifically,youwillwanttoknowhowmuchcashwasgeneratedfromoperations,howmuchcashwasused,andwhetheryournetcashpositionsimprovedordeterioratedduringtheyear.Incondensedform,yourstatementmightlooklikethis:
ABC Corporation: Flow of Funds (000s) Netcashprovidedbyoperations $37,000
Usesofcash: Dividends (20,000) Interest(netoftax) (5,000) Financingactivities 7,000 Increase(decrease)innetcash $19,000 Netcashbalance— beginningofyear $15,000 Netcashbalance—endofyear $34,000
Inthiscase,thenetcashgeneratedbyABCCorporation’soveralloperationswasmorethansufficienttotakecareofinterestchargesandaheftydividendpayment.Moreover,afinancingprovidedafurtherincrementtocashresources.Allinall,cashandcashequivalentsmorethandoubledduringtheyear—anadmirableperformance.
➤ Observation:Thedefinitionofnet cash provided by operationsisthekeytothestatement.Normally,thisfigureencompassescashraisedfromsales,lessout-of-pocketcostsofgoodssoldandotherout-of-pocketexpenses. Cash salesmeansjustthat.Notesandaccountsreceivabledonotqualifyandmustbedeductedfromsales.However,ifnotesoraccountsreceivabledecline,extracashiscomingintothecompanyandsalesshouldbeadjustedupward.Cash cost of goods soldconsistsoftheactualdollarsspentformanufacturingduringtheperiod.Anincreaseinin-ventorymeansthatextracashwasspent,sothecostofgoodssoldshouldbeadjustedupward.Adownturnininventorieslowersyourcostofgoodssold.Conversely,adecreaseinaccountsornotespayableindicatesadditionalcashpaymentsandraisesthecostofgoodssold,whileanincreaselowerstheitem.
Mastering Business Finance / 53
Keepinmindthatyoumustalsoadjustotherexpensestoreflectcashtransactions.Ifaccruedliabilitiesdeclined,cashwasusedtopaythemoff,soaddthatamounttocashexpenses.Anin-creaseinaccruedliabilitiesshouldbedeductedfromcashexpenses.Ifprepaidexpensesrise,addtheamounttocashexpenses;iftheydecline,reducecashexpensescommensurately.
MakingYourCashCountBeawareoftheopportunitiesthatcanenhancethecashyouhaveonhandtomeetshort-termexpenses.Forexample:Participationinelectronicfundstransfer(EFT)programsgenerallyleadstoareductioninpaymentcosts,comparedwiththeuseofchecks.Moreover,byarrangingfordiscountsinreturnforfastpayment,youcanreducereceivablecarryingcosts.
Alsoconsiderkeepingyourmoneyinmoneymarketaccounts.Bycombiningyourpresentcheckingaccountwithamoneymarketdepositaccount,youcanputyourliquidassetstoworkandsaveyourselfmostactivityfeesinthebargain.Lookforotherwaysorprogramsthatbankshavetoimprovecashmanagement.
Managing a Financial EmergencyEvenifyoumakealltherightmovesinmanagingyourcashflow,includingreliableforecasts,accurateanalysisreportsandup-to-dateliquiditystudies,youmaystillwindupinthemidstofafinancialemergency.Thereasonissimple:Manysuchemergenciesarecausedbyeventsoutsidemanagement’scontrol,suchasaninternationalfinancialcrisisorasevererecession.
Allfinancialemergencieshaveonecommoncharacteristic:Ifnotdealtwithquickly,theresult-ingdilemmascreatemoreproblemsandbecomeadragoneveryfacetofoperationandplanning.Forthisreason,afinancialcontingencyplanshouldbepartandparcelofeverycash-managementprogram.Theobjectiveofyourfinancialcontingencyplanshouldbetoquickenyourresponsetimetounforeseenfinancialstrains.Notwofinancialcontingencyplanswillbethesamesimplybecausenotwocompaniesarealike.Nevertheless,everyplanshouldcontainbasicelements:● Develop an early warning system: Earlier,weobserved that earlywarning is thekey to
effectivecashmanagement.Nowhereisthismoretruethanindealingwithacashcrisis.
Thefirststepistodeterminewhichkeyvariableshavethegreatestimpactonthefinancialviabilityofyourfirm.Thesevariableswilldifferfromfirmtofirm.Forsome,inventorieswillbetheculprit.Stillothersmightfindloaninteresttobethechiefburden.
Also,keepclosewatchontheassumptionsthathavebeenbuiltintoyourcash-flowforecasts.Oftentimes,thefactthatoneormoreoftheassumptionshaveprovedinvalidistheearliestwarn-ingsignofimpendingdifficulty.Forinstance,ifyourforecastassumesthatinterestrateswilldriftlowerandtheygoupinstead,yourcompanycouldbeheadedfortrouble,particularlyifyouwillneedtodosomefinancing.
Further,youshouldtakeacloselookatyourcompany’shistorytofindthecauseandcureofpastfinancialcrises.Historymaynotrepeatitself;butevenifitdoesn’t,yourknowledgeofhowpastdifficultieshavebeenovercomeshouldyieldpositiveresultswhendealingwiththenextcrisis.● Set your priorities:Onceyouhaveidentifiedanemergingfinancialcrisis,youwillneedto
knowthefollowing:(1)whatcanbedone;(2)howlongwillittake;and(3)howmuchcashyoucanraise.Thebestwaytoobtainthisinformationistoestablishalistofpriorities,organizedaroundthefourtypesofmanagementdecisionsdiscussedinthebeginningofthissection.Tothat,youcouldaddpotentialfinancingsources,soyourprioritylistprobablywouldwinduplookingsomethinglikethesampleonpage54.
54 / Business Management Daily
➤ Observation:Eachtypeofactionhasitsownstrengthsanddrawbacks.Forinstance,tim-ingchangesareeasytoimplementbutcangoonlysofarandwillmerelydelaytheinevitableinaprotractedcrisis.Volumechangescanchangecash-flowpatternsinahurrybutareeffectiveonlywhentheemergencyisrelatedtodecliningsales.Policyactionsofferthemostfertilefieldforcuttingexpenses,buttheytaketimeandcanalsodelayarecovery.Allthingsconsidered,thebestapproachusuallyinvolvesacombinationofdecisions,eachsupplementingtheother.● Establish an emergency reserve:Onceyouunderstandwhatkindofactionscanbetakenin
anemergencyandhowlongtheymighttake,youcansetupasortofinsurancepolicyintheformofanemergencyreserve.
Thesizeofthereserveisuptoyou.Itshoulddepend,however,onthelengthoftimeitwilltaketomobilizeyourothercashresources,andtheestimatedsizeofacashdrainduringanemer-gency.Forexample,ifyouestimatethatitwouldtakefourbusinessdaysforaninitialemergency
Priority List
Type of Action Estimated Cash Response Time
Timing Changes Speed Collections ____________ ____________ Delay Supplier Payments ____________ ____________ Delay Capital Expenditure ____________ ____________ Other ____________ ____________
Policy Changes Reduce Inventory ____________ ____________ Reduce Dividend ____________ ____________ Cut Capital Expenditure ____________ ____________ Reduce Expenses: Administration ____________ ____________ Production ____________ ____________ Sales ____________ ____________
Volume Changes Cut Part‑Time ____________ ____________ Cut Overtime ____________ ____________ Cut Shift ____________ ____________ Layoffs ____________ ____________
Irreversible Policy Changes Liquidate Assets ____________ ____________ Financing: Short‑Term ____________ ____________ Long‑Term ____________ ____________ Equity ____________ ____________
Mastering Business Finance / 55
responsetoyieldcashandyourmaximumcashdraincouldbeashighas$5,000perdayinanemergency,youwouldneedareserveof$20,000forfullprotection.
Tobeeffective,thereservemustalwaysbeavailableatamoment’snotice.Therefore,mosttraditionalinvestments,suchasTreasurybills,areout,eventhoughtheymaybeperfectlysafe.Usually,suchreservesareheldinmoneymarketfundsorinaninterest-bearingaccount.However,anunusedlineofcreditwouldsufficeifthefundswerecommittedbythebank.
Summary:Thecashmanagementsystemsetforthinthissectioncanmakeaconsiderablecontributiontoyourfirm.Thoughtfullyused,itwillidentifycash-flowimbalancesbeforetheybecomemajorproblemsandpointthewaytowardtheirsolutions.Consequently,whenyourcashflowisonanevenkeel,youcandevotemuchmoretimetoanotherimportantmatter:buildingyourcompany’srevenuesinascopeandsequencethatcontributedirectlyandeffectivelytoanoverallprofitableoperation.
56 / Business Management Daily
CapitalInvestmentBasics
Now thatyouhaveahandleonbudgetandcashflow, it’s time tomoveaheadwithnew projects.Butfirstyoumustanswerthesequestions:(1)Isthereenoughcapital?(2)What
projectswillgetpriority?Thebesttime—indeed,theonlypropertime—tomakecapitalinvestmentdecisionsiswell
beforetheactualfundsareneeded.Fartoooften,capitalspendingplansaremadeonacrisisbasis,withthe“squeakywheelgettingthemostgrease.”Aslickpresentationforsomeone’spetprojectisnotruebasisforcommittingpartofthefirm’sfinancialresources,nomatterhowwellintentionedthatprojectmaybe.Asamanagerwithdecision-makingauthority,youneedalong-termapproach—asystemthatwillenableyoutoanalyzeeachproposalandthencompareitwithotherpossibleprojects.
HowtoPrepareaCapitalInvestmentProposalSoonerorlater,allseriouscapitalspendingproposalsaresubmittedforinclusioninacapitalbudget.Theretheyareclassified,analyzedandevaluatedbeforemanagementmakesafinaldecisiononwhichproposalsaremostsuitedtothefirm’sneedsandobjectives.Keepinmind,however,thatasuccessfulcapitalinvestmentprogrammusttakeyourcompany’slong-rangegoalsandobjec-tivesintoaccount.Ideally,youandyourstaffshouldprovideinputingeneratinganddevelopingcapitalspendingproposals.Youshouldalwaysthinkintermsofcontributingtooverallbusinessstrategieswhenchoosingamongvariousspendingproposals.
Thislinkwithstrategicplanningcanbeaccomplishedinavarietyofways,dependingonyourcompany’ssizeandthecomplexityofitsoperations.Followingisabriefrundownofthestepstotakeinpreparingacapitalspendingproposal.Theymirrormanyofthestepsyourfirmusesinpreparingacompany-widecapitalbudget.● Establish objectives:Tosetyourdepartmentontherightgrowthplan,youmustfirstdecide
whereyouwantittogo.Youmustsetlong-termobjectivesandtakeintoaccounttopmanage-ment’sexpectationsforthefuture.
● Develop strategies:Oncebroadobjectiveshavebeenestablished,yourdepartmentcanstarttoconsidervariousstrategiesthatwouldhelpyourcompanyachieveitslong-termobjectives.
● Present proposals:Makeeachproposalasdetailedaspossibleandincludeestimatedcostsandpreliminaryprojectionsofpossiblesavings.
Allthesestepsareessentialbecauseyourplanswillbecompetingwiththoseofotherunitsinthecompany.Uppermanagementwillevaluateandcompareeachunit’sspendingplans.Thosenotfittingintostrategicgoals,orthatdonothaveagoodbalancebetweenfinancialstabilityandgrowthpotential,willenduponthechoppingblock.
ClassifyingCapitalSpendingProjectsMostfirmstendtotreatallcapitalspendingprojectsalike,anapproachthatcansometimesleadtoseriouserrorsin judgment.Thereareatleastfourbroadcategoriesofcapitalprojects,eachrequiringadifferentplanningapproachandcorporatestrategy.
8
56
Mastering Business Finance / 57
1. Mandated expenditures:Theseareexpendituresrequiredbylaw,suchasOSHAsafetyregula-tionsorEPArequirements.Inaddition,youcanincludespendingprojectstoprotectagainstproductliabilitylawsuitsorpossibleproductrecall.
2. Maintenance expenditures:Projectsinthiscategoryincludeallthosenecessarytomaintainproductionlevels.Existingfacilitiesorequipmentoftenrequirerepairsorreplacement.Be-causeyourcompany’soutputwillbeaffectediftheexpendituresarenotmade,youshouldgivecapitalspendingformaintenanceahighpriority.
3. Cost-saving expenditures:Thiscategoryincludesallprojectsdesignedtomakecurrentopera-tionsmoreefficientorproductive.Cost-savingproposalsusuallyinvolveachoicebetweentheexistingmethodandproposedexpenditure,sotheyshouldalwaysbesupplementedbycash-flowprojections.
4. Growth expenditures:Thisisatoncethemostimportantandthemostelusivecategoryofcapitalspending.Itincludesallexpendituresdesignedtostimulateyourcompany’sgrowth,whetherbyintroducingnewproducts,enteringnewmarkets,purchasingequipment,addingfacilitiesormakingacquisitions.
Althoughcapitalexpendituresmadeforgrowthcanexertaprofoundlong-terminfluenceonafirm,itisusuallypossibletodeferthemwithoutunduepenalties.Forthisreason,youshouldputgrowthinvestmentsatthelowendofyourcapitalbudgetpriorityscale.Seekfundingformandatedandmaintenanceprojectsfirstbecausetheyarenecessarytokeepthefirmfunctioning.Nextcomecost-savingprojects,primarilybecausetheycanhaveaninstantimpactonthebottomline.Onlyafterspendingplansforthefirstthreecategoriesarefinalshouldyouturnyouratten-tiontogrowthprojects.
Avoiding Common PitfallsNosystem forallocating capital resources is foolproof.Youcan,however, cutdownonyourchancesofmakingamistakebyexploringthefollowingalternativeswhenplanningyourcapitalinvestmentproposal:● Look for something better.Resistthetendencytoassumethattheproposalsthatbubbleup
fromyoursubordinatesarethebestavailable.Tostrengthenyourplanning,solicitideasfromthewidestpossiblerangeofdepartments.
● Be ready to branch out.Anothercommonfailingisthetendencytoconcentrateonthefamiliarwhenseekingfundallocations.Toooften,innovativeprogramsareequatedwithriskypro-grams,andthereforedisregarded.Alwaysbereadytoacceptchangeifasoundbusinesscasecanbemadeforit.
● Look to the longer term.Inmanyfirms,projectswithashortpaybackperiodgettheinsidetrack.Management tends to think in termsof current-year results andoverlooksprojectsthatpromiseonlylong-termprofitopportunities.However,theprimarypurposeofcapitalinvestmentistoensurethelong-termprofitabilityofyourfirm.Thus,whileshort-termprofitsareimportant,alwaysleaveroomforprojectsthatwillpayoffoverthelongerterm—andbepreparedtoargueforthem.
● Follow up on your capital program.Onceaprojecthasbeenapproved,makeanefforttoensurethatitmeetsstatedobjectives.Thiswillassistyouinspottingproblemsearlyonandenhancetheeffectivenessoftheprogram.
58 / Business Management Daily
CalculatingYourTrueCapitalCostsBeforeyoucanmakean intelligentdecisiononacapital investmentproject,youwillneedtofindouthowmuchtheprojectwouldcost.Thenyoumustcomeupwithareasonableideaoftheexpectedrateofreturn.Knowingthesefactswilltellyouwhetheryou’reinastrongpositiontorequestanallocationofyourfirm’slimitedresources.
Assessing the Cost of Debt
Notethattheinterestrateonloansorbondsusedinfinancingaprojectisaffectedbythenatureofthefirm’sothercommitments.Ifafirmhascommitteditselftoseveralhigh-riskprojects,itwillusuallyberequiredtopayarelativelyhighinterestrateonanewundertaking,whetherornotthisventureisriskyinitself.Otherfactorsaffectingafirm’scostofdebtincludethecompany’sdebt/equitypositionandtheeconomicoutlookforitsindustry.
Forthesereasons,itisneversafetoassumethatthedebtcostsusedtojustifyoneprojectwillbeapplicabletoanother.Eachtimeyoustarttoreviewanewproject,takethetimetofindoutyourcompany’scurrentcostofdebtfromyourfirm’sfinancedepartment.Becauseinterestexpenseisadeductibleitem,thecostoflong-termdebtshouldalwaysbeexpressedasanafter-taxfigure.Apartfromthat,figuringyourcostofdebtisafairlystraightforwardprocess.Merelyusetherateofinterestthatyourbankwouldchargeforadditionalborrowing;applyyourcurrenttaxratetoobtaintheafter-taxcostofyourdebt.
Example:Ifyourcompanyistaxedat34percentandyourinterestrateonanewloanwouldbe12percent,yourafter-taxdebtcostcomesto7.9percent(12percentx66percent=7.9percent).
What Are Equity Costs?
Companymanagersgenerallyviewequitycapitalascostfree.Theoretically,youdonothavetopaythecapitalback,soit’sfree,particularlyifyourcompanydoesnotintendtopaydividendsthatyear.
Fromastockholder’sviewpoint,however,theoutlookisdifferent.Everydollarofearningsretainedinthefirmisadollardeniedtothestockholders.Inasense,itisa“hidden”costforstock-holders,almostakintoanewinvestmentinthefirm.Thereasonthatstockholdersmaintaintheirinvestmentisthepromiseoffuturedividendsand/orcapitalappreciation(thatis,anincreaseinshareprices).Sincebothdividendsandsharepriceimprovementdependonfutureearningspershare,itisthemostimportantfactorindeterminingyourequitycosts.
Theeasiestwaytocalculateyourequitycostsistousetheinverseofthewidelyusedprice/earningsratioasameasure.Ifyouhaveafirmideaofthevalueofyourcommonstock,youcaneasilyworkoutyourownprice/earningsratio.Ifnot,youcanusetheP/Emultipleofasimilarpublicly tradedcompanyasaguide.Onceyouhaveobtainedanappropriateprice/earningsmultipleforyourfirm,merelydividethenumeral1bythatmultipletofindyourcapitalcost.
Illustration:Youexpectyourfirmtoearn$1.75persharethisyear.Yourcompany’scommonstockiscurrentlysellingfor$20.Thus,yourprice/earningsmultipleis11.4($20÷$1.75).Inotherwords,youneed$1inearningstoraise$11.40incapital,acostrateof8.8percent(1÷11.4).
Alternatively,youfindthatsimilarpubliclytradedcompaniesaresellingatP/Emultiplesrangingfrom7.5to8.5.Takingthemedian,youdeterminethat,foreach$1ofearnings,youcanraise$8innewequitycapital.Thus,theequitycostratebecomes12.5percent(1÷8).
➤ Observation:Whendiscussingequitycapital,almosteveryonethinksstrictlyintermsofcommonstock.Technically,that’snottrue.Preferredstockisalsoequitycapitalbutwithadiffer-
Mastering Business Finance / 59
ence.Itispermanentcapital,butitbearsafixeddividendrate,muchlikeabond.Ifyourcompanyhaspreferredstockoutstanding,youshouldbyallmeansdetermineitscost.Sincemoststraightpreferredissuessellonayield(orinterest-rate)basis,thebestwaytocalculateyourcostistofindapubliclytradedpreferredissuesimilartoyourown.
Illustration:Ifyourcompanyhasa5percentpreferredissueoutstandingwitha$100parvalue,youmightnotethatasimilarissue,GeneralMotorspreferred,payinga$5dividend,issellingatabout$48,providingayieldof10.4percent.Theyieldbecomesyourcapitalcostbecausethatistherateyouwouldhavetopaytoraiseadditionalfundsviathepreferred-stockroute.
WaystoMeasureYourExpectedReturnOnceyouhaveestablishedtheprobablecostofyouranticipatedcapitalinvestment,youwillneedameaningfulmeasureoftheproductivityofthatcapitalsothatyoucanrealisticallydecideontheproject’sworth.Formanyfirms,thecostofcapitalbecomes,ineffect,the hurdle rate—theratethatanynewprojectmustearntoqualifyforapproval.
Attheoutset,youshouldrecognizethatallmethodsofcalculatingtheanticipatedreturnofacapitalinvestmentrequireapeekintothefuture.Thus,nomatterhowsophisticatedtheymaybe,theyarecertaintobefaultytosomedegree.Becauseofthis,manycompaniesseektoimprovetheoddsintheirfavorbyusingmorethanonemethodofcalculatingtheexpectedreturn.Theniftheproposedprojectfailstomeasureuponmorethanonescale,managementcandiscardit.
Therearethreecommonlyusedmethodsofevaluatingcapitalinvestmentprojects,eachwithitsownstrengthsandweaknessesandanumberofvariations.Thereisnorightorwrongmethod.Thepropermethodforyouistheonethatbestfitsyourneeds.
The Payback Method
Thepaybackmethodistheoldest,mostcommontechniqueofevaluatingcapitalexpenditures.Today,however,itisalmostalwaysusedinconjunctionwithoneofthemoresophisticatedmeth-odsofcapitalinvestmentevaluation.
Thisstraightforwardcalculationis:
Original net investment ÷ Annual earnings after tax = Depreciation = Payback period
Thecalculationtechniqueusedinthepaybackmethodisamodelofsimplicity.Thecapitaltobeinvestedintheproject,pluscosts,ismeasuredagainstprobablecashflowfromtheinvest-ment.Fromthismeasurement,theamountoftimeneededtobreakeven,orthepayback period,iscalculated.
Illustration:Let’ssaytheABCCompanypurchasesanewmachinefor$70,000thatwillrequireanother$40,000ininstallationandtrainingcosts.Thus,itstotalcapitalinvestmentis$110,000.Thecompanyalsoexpectsthisnewmachinetoimproveitscashflowattherateof$25,000peryear.Youwouldcalculatethepaybackperiodasfollows:
Capitalinvestment $110,000 Additionalcashflowperyear $25,000
Unfortunately,itisararecapitalinvestmentthatthrowsoffequalamountsofcashfloweachyear.Normally,theamountswillvaryeachyear,asbusinessconditionschange.Morelikely,thecashflowfromtheinvestmentdescribedabovewilllooklikethis:
= =4.4years
60 / Business Management Daily
Year 1 2 3 4 5
Annualcashflow($000) $30 $20 $25 $25 $30 Cumulativecashflow($000) $30 $50 $75 $100 $130
Becausethecapitalinvestmentwillhavegeneratedtotalcashflowof$100,000afterthefourthyear,and$130,000afterthefifth,weknowthatthepaybackperiodliessomewherebetweenfourandfiveyears.
Tofindoutexactlywhen,merelydividetheamountnotyetpaidbackattheendofthefourthyearbytheamountofcashflowprojectedforthefifthyear.Inthiscase,itis:
CapitalshortfallatendofYear4 $10,000 CashflowprojectedforYear5 $30,000
Thus,thetotalpaybackperiodforthisparticularinvestmentbecomes4.3years,somewhatshorterthanthepaybackperiodfortheprojectwhenequalcashflowisassumed.
Therearegoodandvalid reasons for the enduringpopularityof thepaybackevaluationmethod,eventhoughnowitisusuallyusedinconjunctionwithotherformsofmeasurement.Themostimportantreasonsare:● Simplicity.Thepaybackmethodiseasytocalculateandjustaseasytounderstand.● Good risk indication.Thepaybackmethodgivesyouasoundassessmentofyourrisk.The
longerthepaybackperiod,thegreatertherisk.
Therearedefinitedisadvantagestothepaybacksystem,which,insomecases,outweightheadvantages.Hereareafew:● No profit measurement.Thepaybackmethodmeasurestheabilityoftheprojecttorecoup
yourinvestment.Itsaysnothingaboutprofit.Thus,itisdifficulttostrikeacomparisonwithotherinvestments.
● No rate of return.Paybackanalysistakesyouonlytothedatewhenyourinvestmentisre-turned.Thus,notruerateofreturnisascertainablebecausearateofreturnwouldconsidertotalcashflowovertheproject’slife.
● No consideration of money’s time value.Thepaybackmethodgivesthesamevaluetocashflowtobereceived,say,fiveyearsfromnow,ascashreceivedtoday.Inaperiodofhighinter-estrates,thiscanbeaseriousdrawback.
Overtheyears,anumberofvariationsofthepaybackmethodhavecroppedup,primarilyasaresultofattemptstoadaptthepaybackmethodtotheneedformoreprecisedata.Althoughthesevariationscanhelp,theyseldomrepresentthewholeanswer.
Thediscounted payback methodisanattempttowedthepaybackmethodtothediscounted cash flowconcept(seebelow),whichgivesrecognitiontothetime value of money.Youapplyadiscountfactorthatwillallowthediscountedcashflowtoreachzero,orclosetoit,overasome-whatlongerperiodthanwouldnormallybeused.Thismethodisnotfullysatisfactorybecauseitusesanarbitrarydiscountrate.Ideally,thediscountrateshouldrepresentsomesortofcorporateobjective,suchascapitalcosts,rateofreturnandaverageindustryreturn.
Thereciprocal payback techniquemerelyreverses themethodofcalculating thepaybackperiodinordertogiveanapproximatereturnoninvestmentrate.Forinstance,theapproximatereturnoninvestmentforourpreviousexamplewouldlooklikethis:
$25,000 $110,000
= =0.3years
=22.7%
Mastering Business Finance / 61
Keepinmind,however,thatthisis,atbest,anapproximation.Moreover,itshouldnotbeusedifcashflowsvaryfromyeartoyear.
UsingNetPresentValuetoMeasureReturnIfyourcompanyhasnotyetusedthenetpresentvalue(NPV)methodofmeasuringtherateofreturnonaproposedcapitalinvestmentproject,chancesaregoodthatitwilldosointhenearfuture.Duringthepastseveralyears,NPVhasbecomeoneofthemostcommonlyusedmethodsofcapitalinvestmentevaluation.
Foranumberofreasons,thepopularityoftheNPVmethodhasgrownrapidly.Mostimpor-tant,itrecognizestheimpactthatinflationorhighinterestratesarelikelytohaveontheworthofanewcapitalinvestment.However,evenwiththecoolingofinflationandanaccompanyingsoftnessininterestrates,theNPVmethodislikelytoretainmost,ifnotall,ofitspopularity.Herearethereasonswhy:● Recognition of the time value of money.Essentially,theconceptoftimevalueholdsthata
dollarreceivedtodayisworthmorethanadollartobereceivedlaterbecause(1)inflationerodespurchasingpower,and(2)adollarreceivedtodaycanbeinvestedtoearninterest.
● Allowance of comparison of projects.YoucanapplytheNPVtechniquetoalltypesofprojectsandtherebycancompareandrankyourvariousoptions.
● Applicability for the life of an investment.NPVcanbeusedtoevaluateaninvestmentoveritsentirelife.
AlthoughtheseadvantagesgiveNPVaconsiderableedgeoverthepaybackmethodinsomeareas,don’tmakethemistakeofthinkingtheNPVmethodwillsolveallyourcapitalevaluationproblems.NPVhassomebasicflawsthatcan,attimes,leadtounjustifiedconclusions.First,itisdifficulttoforecastcashflow.NPVrequiresthatcashflowfromaproposedcapitalinvestmentventurebeprojectedforatleastfiveyears,andsometimesmore.Obviously,suchforecastsmaybesubjecttoseriouserror,particularlyinavolatilebusinessclimate.Second,thereisanassump-tionofsteadyreinvestment.TheNPVmethodassumesthatallcashflowsfromtheprojectcanbereinvestedatachoseninterestrate.(Thisrateiscalledthediscount rateandisusuallyequivalenttothecompany’scostofcapital.)Thismaynotalwaysbepossible.Finally,NPVdoesnotmeasuretheprofitabilityofaparticularproject,onlythecashflow.Actualprofitsinfutureyearsmayturnouttobearlittleresemblancetocash-flowprojections.
EventhoughtheNPVmethodisnot,inandofitself,abasisforjudgingtheworthofcapitalspendingproposals,itcanbeausefultoolinyourdecision-makingprocess.Aswiththepaybackmethod,however,itusuallyworksbestwhenusedinconjunctionwithotherevaluationmethods.
UnderstandingtheDiscountingConceptBothNPVandtheinternal rate of return (IRR), thenextevaluationmethodwewilldiscuss,dependontheconceptofdiscounted cash flow (DCF).DCFisbasedonaprinciplethatmostbusinesspeopleinstinctivelyunderstand,butneverthelessfinddifficulttoconvey.Insimpleterms,DCFrecognizesthatmoneyhasacertaintimevalue.Adollarreceivedtodayisworthmorethanadollartobereceivednextyearbecausethedollarreceivedtodaycanbeinvestedtoearnmoremoney.Specifically,each$1thatyoureceivetodayisworthroughly$1.08thefollowingyearsimplybecauseyoucanreinvesttoday’sdollartoearnarisk-free8percentatpresent.
Inotherwords,adollarthatyouarescheduledtoreceivenextyearisactuallyworthonly$0.92intoday’sdollar.That’sadiscountof8percenttomakeupfortheinterestforgone.Simi-
62 / Business Management Daily
larly,adollartobereceivedtwoyearsfromnowwouldbeworthapproximately$0.86,withthe8percentdiscountcompoundedoverthetwo-yearperiod.Overathree-yearperiod,your$1wouldbeworthonly$0.79,givenathree-year8percentdiscount.
Inanutshell,that’showthetechniqueofdiscountedcashflowworks.Theprojectedcashflowfromaparticularprojectisdiscountedyearbyyear.Intheory,thefinalfigurearrivedatrepresentsthemoneytobereceivedintermsofcurrentdollars.
DiscountingtoFindNPVOnceyou’vegraspedtheconceptofdiscountedcashflow,itisasimplemattertocalculatenetpresentvalue.First,selectanappropriatediscountrate,onethatrepresentstheminimumrateofreturnthatisacceptablefornewcapitalinvestments.Usually,theaveragecost-of-capitalrateisusedasahurdlerate,butyoucansubstituteotherrates.Thediscountrateshouldbeinkeepingwithyourcompany’slong-andshort-termobjectives.Afterselectingadiscountrate,applyittotheprojectedcashflowsfortheproject.Finally,totalthecashflows.Iftheresultsarepositive,theprojectwilltheoreticallyyieldaprofit.Ifnot,thereisgoodreasontoquestionwhetheryouwillbeabletorecoupyourinvestment.
Illustration:SaytheABCCompanyisnowconsideringa$50,000capitalinvestmentinanewpieceofequipment.After$10,000ininstallationcosts,thenewequipmentisexpectedtoyieldannualnetcashflowsasfollows:
Year 1 $15,000 Year 2 $15,000 Year 3 $15,000 Year 4 $17,500 Year 5 $20,000
BecausetheABCCompany’saveragecapitalcostrate(see page 58)is8.8percent,itsetsadis-countorhurdlerateof9percent.Eachpaymentisthendiscountedbyusingapresentvaluefactortable,suchastheoneonpage63.HereishowtheNPVcalculationswouldlook:
Year Net Cash Flow Discount Factor at 9% Present Value
0 ($60,000) — ($60,000)1 15,000 .917 13,7552 15,000 .842 12,6303 15,000 .772 11,5804 17,500 .708 12,3905 20,000 .650 13,000Total $22,500 NPV $3,355
Asyoucansee,the$22,500theoretical“profit”projectedfortheinvestmentbeforediscount-ingboilsdowntoamoremundane$3,355onanNPVbasis.Nevertheless,ABCshouldconsidertheinvestment:Thecompanywouldnotonlyrecouptheinvestmentbutalsoearnaprofitinthebargain.
Mastering Business Finance / 63
Toillustrate,however,howevenamoderateshiftinthediscountratecanaffectNPVcalcula-tions,let’sassumeABCdecidesthatthecostofcapitalwasclimbingandthat,fromhereonin,itwoulduseahurdlerateof11percent.NowtheNPVcalculationswouldlooklikethis:
Year Net Cash Flow Discount Factor at 11% Present Value
0 ($60,000) — ($60,000)1 15,000 .901 13,5152 15,000 .812 12,1803 15,000 .731 10,9654 17,500 .659 11,5325 20,000 .593 11,860Total $22,500 NPV $ 52
Nowthe$22,500profithasbeentransformedintoaminusculegainofonly$52overthefive-yearspan.Theproject,therefore,isonlymarginallyacceptable.Asyoucansee,yourexperiencewiththeNPVevaluationmethodwillheavilydependonthehurdleratethatyou’vechosen.
UsingInternalRateofReturnThe internal rate of return (IRR)evaluationmethodisakintonetpresentvaluebecauseitisalsobasedonthediscountedcashflowprinciple.WhenusingNPV,however,youalwaysassignadis-countrate.IntheIRRmethod,youderiveadiscountratethroughtrial-and-errorcalculation.TheIRRmethodattemptstodeterminetheinternalrateofreturnofaproposedcapitalinvestmentbycalculatingthediscountrateneededtobringtheNPVtozero.Then,ifthecalculatedrateofreturnisgreaterthantheaveragecostofcapital,theprojectisacceptable.Ifnot,theprojectisrejected.
Byusingaderiveddiscountrateratherthananassignedrate,theIRRmethodeliminatesoneofthepossiblemisusesoftheNPVapproach:arbitrarilyusinganunjustifiedhurdlerate.Never-theless,theIRRmethodisstillvulnerabletothebasicflawsfoundinanyevaluationsystemtiedtodiscountedcashflow:namely,thewidemarginforerrorinforecastingcashflows.
Evenwiththesecaveatsinmind,however,theIRRcanbeausefultoolinmeasuringtherateofreturnofacapitalinvestmentproject.Oncedeveloped,aninternalrateofreturncanbecomparedtothatforotherprojectsandtoyourcompany’soverallobjectives,aswellasthecostofcapital.
Table 1: Present Value FactorsNo. of Discount RateYears 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 .952 .943 .935 .926 .917 .909 .901 .893 .885 .887 .870 .862 .855 .848 .840 .833 2 .907 .890 .873 .857 .842 .826 .812 .797 .783 .770 .756 .743 .731 .718 .706 .694 3 .864 .840 .816 .794 .772 .751 .731 .712 .693 .675 .658 .641 .624 .609 .593 .579 4 .823 .792 .763 .735 .708 .683 .659 .636 .613 .592 .572 .552 .534 .516 .499 .482 5 .784 .747 .713 .681 .650 .621 .593 .567 .543 .519 .497 .476 .456 .437 .419 .402 6 .746 .705 .666 .630 .596 .565 .535 .507 .480 .456 .432 .410 .390 .370 .352 .335 7 .711 .665 .663 .584 .547 .513 .419 .452 .425 .400 .376 .354 .333 .314 .296 .279 8 .677 .627 .582 .540 .502 .467 .434 .404 .376 .351 .327 .305 .285 .266 .249 .233 9 .645 .592 .544 .500 .460 .424 .391 .361 .333 .308 .284 .263 .243 .226 .209 .19410 .614 .558 .508 .463 .422 .386 .352 .322 .295 .270 .247 .227 .208 .191 .176 .16215 .481 .417 .362 .315 .275 .239 .209 .183 .160 .140 .123 .108 .095 .084 .074 .06520 .377 .312 .258 .215 .178 .149 .124 .104 .087 .073 .061 .051 .043 .037 .031 .026
64 / Business Management Daily
Illustration:AssumethatABCCompanyisconsideringa$60,000capitalinvestmentinnewequipment.Expectedcashflowsarethesame,butthistimewewillbeusingtheIRRevaluationmethod.FrompriorNPVcalculations,weknowthattheinternalrateofreturnissomewherebetween11percent,whereanarrowprofitwasrecorded,and12percent,whichwouldcertainlyproducealoss.(See box for the IRR calculation.)
Tofindtheexactrate,weinterpolate.First,takethedifferencebetweentheNPVat11percentandtheNPVat12percent.Inthiscase,thedifferenceis$1,552.Next,dividethepositiveNPVof$52bythe$1,552difference.Thenaddthequotienttothelowerdiscountratetogettheinternalrateofreturn,whichequals11.03percent.
IntheIRRmethod,thehighertheinternalrateofreturn,thebetter.Therefore,withan11.03percentrateofreturnandaveragecapitalcostsofonly8.8percent,theABCCompanywouldbewelladvisedtogivethisprojectcloseconsideration.
➤ Observation:Thesearesoundreasonsforyoutouseallthreecapitalspendingevaluationmethodsdescribedpreviouslywhenpreparingacapitalbudget.Forinstance,apaybackanalysisoftheABCCompanyprojectwoulddisclose,attheoutset,thatthiswasamedium-riskproject,withpaybackcalculatedinalittlelessthanfouryears.Inaddition,theNPVanalysisindicatesthatthenewmachinerywillmorethanreturnitsinitialinvestmentinthenextfiveyears.Finally,theproject’sIRRstandswellabovethecompany’shurdlerate.Becausetheprojectmeasuresupfavorablyunderallthreeevaluationscales,ABCCompanymanagementcanbefairlyconfidentthatitwillcontributetoprofitsoverthenextseveralyears.
Inshort,thereisnoneedforyoutopickandchooseamongthethreeevaluationtechniques.Eachisdesignedtogiveyouadifferentinsight,andyoucanprofitfromusingallthree.Equallyimportant,bylookingattheinvestmentfromthreeangles,youavoidplacingtoomuchemphasisononenarrowfact.
Calculating Internal Rate of Return (IRR)
Net Discount Present Discount Present Cash Factor Value Factor Value Year Flow at 11% at 11% at 12% at 12%
0 ($60,000) — ($60,000) — ($60,000)
1 15,000 .901 13,515 .893 13,395
2 15,000 .812 12,180 .797 11,955
3 15,000 .731 10,965 .712 10,680
4 17,500 .659 11,532 .636 11,130
5 20,000 .593 11,860 .567 11,340
$22,500 $ 52 ($ 1,500)
IRR = 11% + ($52 ÷ $1,552) = 11.03%
Mastering Business Finance / 65
TheHurdlePoint:UsesandMisusesAswehavepointedout,ahurdlerateistheminimumacceptablerateofreturnforacapitalspend-ingproject.Originally,theaveragecostofcapitalratewasconsideredthehurdleratebecausenofirmcanaffordtoearnlessthanitscapitalcostsforlong.Overtime,however,theconceptofhurdlerateshaschanged.All-inclusive,company-widehurdleratesaregivingwaytoamoreflexibleapproach.Somehurdleratesareclassifiedaccordingtorisk;othersareassignedaccordingtoinformalguidelines;stillothersarerelatedtothecompany’sstrategicgoals.
Asaresult,therearenohard-and-fastrulesforsettingahurdlerate.Itshoulddependonyourcompany’sobjectives,theriskfactorinherentinyourbusinessandthestrengthofyourcompany’sfinancialunderpinnings.Nevertheless,youshouldkeepsomebasicconsiderationsinmindwhendecidingonasuitablehurdlerateforaproposedproject.
1. It should be based on reality. Thismaysoundobvious,butinfartoomanyfirms,thehurdlepointistheresultofanarbitrarymanagementdecision.Insomecases,thehurdlepointistoohighandresultsinlostinvestmentopportunities.Inothers,itissettoolow,whichusuallyleadstoastrainonprofits.
Yourhurdlerateshouldalwaysbeclosetoyouraveragecostofcapital.Youshouldconsidertheoveralltrendofcapitalcosts.If,forinstance,inflationandrisinginterestratesarelikelytopushcapitalcostshigher,youmaywanttocompensatebyraisingyourhurdlerate.
2. It should bear some relationship to risk.Yourhurdlerateshouldbeadjustedtocompensatefortherisksinherentintheproject.Thehurdlerateforlow-riskprojectsneednotbeashighastherateforprojectswithabove-averagerisks.Thisincludesinternalrisks,suchasfamiliaritywiththeprocess,marketorfacility.Moreimportant,itincludesexternalrisks:thestateoftheeconomy,theoutlookforinterestrates,inflation,thebusinessclimateandsoforth.
3. It should be current.Nohurdlerateshouldeverbesetinstone.Asfinancialmarketschange,yourcostofcapitalwillchangewiththem.Reviewyourhurdlerateatleastonceayear,and involatile times, consider revising it every sixmonths.Asamatterof fact, it is commonpracticeamongmajorcompaniestocalculateaveragecapitalcostsonanannualbasis.Theinformationisthenusuallypassedalongtothevariousoperatingdivisionsordepartments,witheachdeterminingitsownhurdlerate.
Determining Flexible Hurdle Rates
Whenproperlyused,flexiblehurdleratescanprovidereasonableyardsticksforjudgingprospectivespendingproposals,andtheyalsoavoidthepitfallsassociatedwithusingasinglehurdlerate.Toapplyflexiblehurdleratestoyourcapitalspendingprogram,youwillneedtorateeachproposalaccordingtoitsdegreeofrisk.High-riskproposalsshouldrequirearelativelyhighrateofreturntobeacceptable;medium-risk,asomewhatlowerreturn;andlow-riskproposals,anevenlowerrate.Minimum-returnstandardsforeachriskcategoryarebasedonassumed-riskcapitalcosts.Thisapproachinvolvesthreebasic,relativelyeasysteps:● Find appropriate debt/equity ratiosforeachofthecategoriesofrisk.Ifyouweretofinance
ahigh-riskprojectintheopenmarket,youwouldprobablyhavetodosolargelybyrais-ingequitycapital.Thesedays,fewbanksarewillingtotakethechanceoflendingforriskyenterprises.Amedium-riskventurecouldprobablybefinancedwithacombinationofnewequityandabankloan.Inalow-riskventure,yourbankerwouldlendyoumost,ifnotall,oftheneededfunds.
66 / Business Management Daily
Whiletheprecisedebt/equityratiousedforeachriskcategorywilldependonyourindustry,thesizeofyourcompanyandyourownfinancialunderpinnings,thereisageneralpattern.Thedebt/equityratioformostcompanieswillfallwithinthefollowingranges:
High-risk: debt= 0%–20% equity=80%–100% Medium-risk: debt=30%–40% equity=60%–70% Low-risk: debt=80%–100% equity=0%–20%● Calculate after-tax debt and equity costs.Next,establishareasonableafter-taxcostbasisfor
raisingnewdebtandequitycapital.Wecanreferbacktotheexampleusedinourdiscussionofcapitalcosts(see page 58).Wewillassumeaveragedebtcostsof7.9percentandequitycostsof12.5percent.
● Calculate hurdle rates by computing a weighted cost of capital for each category.First,determinewhatpercentagesofthetotalfinancingforagivenprojectwillbeaccountedforbydebtandequity,basedontheguidelinesthatwerementionedabove.Thenmultiplyeachpercentagebytheappropriatecostofcapitaltogettheweighted cost of capital.Thesumoftheweightedcostsisyourminimumreturn,adesirablerateforeachriskclassification.
Illustration:Usingearlierexamples,hereishowtocalculatetypicalhurdlerates:
➤ Observation:Thecrucialelementinusingflexiblehurdleratesisyourassessmentoftheriskinvolvedineachproject.Howdoyoudeterminethedifferencebetweenamedium-riskprojectandahigh-riskone?Thisleadsdirectlytotheareaofriskanalysis,whichwewilldiscussbelow.
AnalyzingYourCapitalInvestmentRisksNocapitalinvestmentprojectiseverwithoutriskbecausethereisnocompletelyreliablewaytoforecastfuturecashflow.Nevertheless,therearevariousdegreesofriskinvolvedindifferenttypesofcapitalprojects.Forinstance,themarketingofanewproduct,orentryintoanewmarket,carriesahigherriskthanothertypesofprojects.Thisisbecausemanagementhasnoexperiencetodrawoninthissituation,whichleadstoimprecisecash-flowforecasts.
Thus,youcanequatetheriskinanygivencapitalinvestmentprojectwiththeprobabilityofavarianceinyourprojectedcashflows.Forinstance,thereplacementofaworn-outmachinewithanewoneisusuallyalow-riskproject.Youhavepreciseknowledgeof(1)whatthenewmachinecando,(2)howmuchmoreefficientitisthantheoldmachine,and(3)thecostsavingsorproductivitybooststhatwillresultfromreplacement.Thus,theoddsofamajordeviationfromcash-flowprojectionsaresmall.
Debt 7.9%x.10 = 0.79 High-risk (10% debt, 90% equity) Equity 12.5%x.90 = 11.25 Capitalcost = 12.04%
Debt 7.9%x.35 = 2.77 Medium-risk (35% debt, 65% equity) Equity 12.5%x.65 = 8.12 Capitalcost = 10.89%
Debt 7.9%x.90 = 7.11 Low-risk (90% debt, 10% equity) Equity 12.5%x.10 = 1.25 Capitalcost = 8.36%
Mastering Business Finance / 67
Ifyouweregivenachoicebetweentwoprojectswiththesamereturn,youalmostcertainlywouldchoosetheprojectwithlessrisk.Thehigher-riskprojectcouldbejustifiedonlybyahigherreturn.Thisisthewhyyoumustmakesomeprovisionforassessingtheriskinaproposedcapitalproject.Withoutknowingtherisk,youarenotinapositiontojudgewhethertheprojectissuitable.
Attheoutset,youshouldrecognizethatriskanalysis isadifficult job.Nomethodofriskanalysisisentirelysatisfactory,andeachrequiresagooddealofexpertiseandjudgmentonthepartofmanagement.Moreover,manyrisksaredifficulttoreducetonumbers.Forthisreason,youshouldregardtheriskanalysismethodsdiscussedbelowastools.Theyarenotsubstitutesforsoundbusinessjudgment.Theydo,however,forceyoutoviewthevariousprojectsinthesamelight,whichhighlightsriskandpermitsyoutocompareallofthem.
Weighted-Risk Analysis
Inthistypeofanalysis,youattemptto isolatethosefactorsthatwouldhavethemost impactoncashflowiftheywerealtered.Youcanidentifyanynumberofkeyvariables,suchasasalesdownturn,thetimeittakestoputtheprojectintoplace,increasedcosts,aneconomicslowdownandmarketingdifficulties.Aftereachkeyvariablehasbeenidentified,itischangedslightlyandNPVisrecalculatedonthebasisofthedifferentcash-flowassumptions.Thentheeffectofthechangeisnotedandranked.
Illustration:TheABCCompanyisconsideringintroductionofanewproductthathasanetpresentvalueof$40,000overfiveyears.ItdeterminesthatthemostcriticalvariablesinitsNPVcalculationsareanticipatedsales,pre-productioncostsanddistributioncosts.Thecompanythenassumesa10percentchangeineachofthesevariablesandrecalculatesNPVinallthreecases.AssumingthefollowingNPVfigures,itsweighted-riskanalysismightlooksomethinglikethis:
Change in Variable Change in NPVSales –10% –30%Distributioncosts +10% –25%Pre-productioncosts +10% –15%
Inthiscase,asalesslowdownproducesthegreatestriskandtrimsthecompany’sNPVby30percent,or$12,000ona10percentsalesdip.Also,ithadbetterkeepawatchfuleyeondistribu-tioncostsifthecompanydoesgoaheadwiththeproject.A10percentrisetherewillcuttheNPVby$10,000.Pre-productioncostsareimportantbutexertlessimpactthanthefirsttwovariables.
➤ Observation:Weighted-riskanalysiscanbeveryinformative,particularlyifyouareastuteenoughtoisolatethekeyvariables.However,thismethodalsohassomelimitations.First,thereisnoprovisionformeasuringtheprobabilityofchangesinthekeyfactors.Also,changesinacombinationoflessinfluentialfactorscouldresultinasubstantialchangeincashflows.
Adjusting for Probabilities
TurnbackonceagaintotheABCCompany’sillustration (pages 62–64).Wehavealreadydemon-stratedthattheprojectwouldbeprofitableatboth9percentand10percentdiscountrates,butwouldproduceonlyamarginalprofitat11percent.Yourcompany’sfinancedepartmenthaslikelydevelopedestimatesoftheprobabilityforeachcostofcapital,basedontheoutlookforyourindustryandeconomicprojections.Obtaintheseestimatesfromthedepartment.
Acompanyestimatestheprobabilityofeachdiscountrateforeachyearthattheprojectwillbeinforce.Then,NPVforeachyearisadjustedfortheprobability.Example:Refertothetable
68 / Business Management Daily
below.InYear1,ABCestimatesonlya10percentchanceofa9percentdiscountrate.Therefore,the9percentNPVof$13,755becomes$1,375($13,755x.10).Similarly,the80percentprobabilityofa10percentdiscountratetranslatesinto$13,635x.80,or$10,908.Addtothatthe$1,351fromthe11percentcolumn($13,515x.10),andtheadjustedNPVforYear1becomes$13,634.Afteradjustingforallfiveyears,NPVisapositive$1,759fortheproject—anindicationthattheABCCompanyshouldproceed.
Theattempttomeasuretheprobabilityofdifferentscenariosaddsanewdimensiontoriskanalysisandcanbequitehelpful.Butrememberthatitisdifficulttoassignprobabilitylevelsfourorfiveyearsintothefuture.
Alternate Scenarios Measure Risk
Withthismethod,youdevelopthreeseparateNPVorIRRstudiesforeachproject.Youassumethat(1)everythingwillgoexactlyasplanned,(2)nothingwillgoright,and(3)thingswillgomoreorlessasexpected,withsomebugs.Thenyoucomparethevaryingdegreeofriskineachproject.Forinstance,youfindtwoprojectswiththesamemidpointNPV,butonewithmuchmoreriskifnothinggoesright.Inthatcase,youwouldprobablychoosetheprojectwiththelowerrisk.
Itisrelativelyeasytocomparedifferentprojectswiththismethod.However,itisalsounre-alisticinthattherearefewprojectslaunchedwhereeverythinggoesright,andjustasfewwhereeverythinggoeswrong.Moreover,thereisnoadjustmentforthevariousprobabilities.
Probability Adjustment—ABC Company
Probability for
Discount Rate Discount Rate Discount Rate Adjusted Year of 9% of 10% of 11% Present Value
1 10% 80% 10% $13,634
2 20 70 10 12,417
3 30 60 10 11,329
4 20 60 20 11,955
5 20 60 20 12,424
Total Cash Flow $61,759
Capital Cost 60,000
Adjusted NPV $ 1,759
Mastering Business Finance / 69
HowtoRaiseMoney
Almosteveryhealthybusinesswilleventuallyreachapointwhenitmustengageincapital formation.Forsomebusinesses,thistimecomesrightatstart-up,whenfundsareneeded
topaytheoverheadcostsassociatedwithlaunchingabusiness.Otherfirmslookforsourcesoffinancingwhentheywanttoexpandormoveintonewserviceareas.
Allthatyou’velearnedinthepreviouspagesisputtothetruetestwhenyou’researchingforcapital.Noteveryinvestorisgoingtowanttotakeachanceonyourbusiness.Tomakeyoursearchforcapitalaproductiveone,youmustshoparoundforaninvestorwhosegoalsandinter-estsmatchyourcompany’s.
Ifyou’reamanagerinasmallercompany,there’sagoodchanceyoumayfindyourselfsittingintheofficeofyourlocalbankoraventurecapitalistwithyourbriefcasefullofratios,abalancesheet,forecasts,etc.Ouraimhereistohelpyougetthemoneyyouneed.
Ifyou’reanonfinancialmanagerinamidsizeorlargecompany,you’relikelytobeaskedtoparticipateinthefund-raisingroutine,especiallyifitinvolvesoneofyourprojects.YoumaynotgotothebankwithyourCFOandaskformoney,butyoushouldbefamiliarwiththeprocesssothatyouknowwhat’sinvolved.Moreover,whenyougobeforeaninternalboardorcommit-teetopresentplansforanewproject,youneedtotakeaprofessional,polishedapproach.Yourplanshouldlooklikeabusinessplan,withadescriptionoftheproject,thecompetitionandtheexpectedpayback.Usethissectionofourreportasachecklistoffactorstothinkaboutbeforeyoupresentyourplan.
KeepaBusinessPlanonHandUnfortunately,manyexecutivesregardbusinessplansasfinancingtoolsthatareprimarilyuse-fulforstart-upcompaniesorforthosejustemergingfromthestart-upphase.Intruth,therearesoundreasonsforyoutohaveanup-to-datebusinessplanonhandatalltimes,nomatterhowsuccessfulorprofitableyourcompany.Asolidbusinessplanisanimportantfinancingtoolatanystageofyourcompany’sdevelopment.
Forexample,yourchancesofraisingequitycapitalwithoutabusinessplanarevirtuallynil.Noinvestmentbanker,venturecapitalistorevenasmallbusinessinvestmentcompany(SBIC)(see page 82)wouldevenconsiderafundingrequestwithoutaformalbusinessplan.Moreover,businessplansareabsolutelyessentialtothesuccessofseriousmergeroracquisitionnegotiations.Eventhoughbanksandotherlendersdonotusuallyrequireabusinessplan(exceptforlong-termloanapplications),awell-structuredplancanmateriallyimproveyourchancesofgettingaloan.
Contents of a Business Plan
Atypicalbusinessplanconsistsofthreemainsections,eachcontainingspecificinformationaboutyourcompany’scurrentbusinessandfinancialposition.Thefollowingisabriefsummaryofeachelement.
Introductory section:Usuallyonlythreetofourpages,thefirstsectionisintendedtogivethereaderabriefoverviewoftheproposal.Itshouldconsistofthefollowing:(1)a title page identifyingthecompanyanditsprincipalofficers,withnames,addressesandphonenumbers;
9
69
70 / Business Management Daily
(2)atable of contents,listingthethreeprincipalsectionsandallmajorsubheadings;and(3)abrief statement of purpose(approximatelyone-halfpage),summarizingtheproposal,spellingouthowmuchmoneyisinvolved,howthefundsaretobeused,howthefirmwillbenefitandhowthefundswillberepaid(inthecaseofaloan).
Descriptive section:Thecommentsinthissectionshouldspelloutyourcompany’scurrentbusinesspositionanditsplansforthefuture.Becertaintoaddressatleastthesefiveareasbydescribing:● Your business. Assuccinctlyaspossible,tellwhatyourbusinessis,howyourunitandwhy
youaresuccessful.● Your market and your com pany’s market niche.Givesomeideaofyourmarket’ssizeand
potentialaswellasyourmarketingstrategy.● Your competition and how you handle it.Mincenowords.Ifcompetitionissevere,sayso.● Your management team. Emphasizethebusinessbackgroundandexperienceofeachmember.
Includesomepersonaldata,suchasage,specialinterestsandplaceofresidence.● How the new capital will be applied.Spelloutwhatprojectsthefundswillbeusedfor.You
shouldbeasspecificaspossible,whichmeansthatyouwillhavetoreachsomeharddecisionsbeforeseekingfunds.
Financial section:Your“financials,”astheyarecommonlytaggedbylendersandotherprovid-ersofcapital,shouldbetargetedatprovidingsupportforthestatementsmadeinthedescriptivesection.Youwillneedbothhistoricaldataandprojectionsforthefuture.StartoffwithaSourceandApplicationofFundingstatement,whichshowsindetailhowtheproceedsofthefinancingwillbeused(forexample,percentagesallocatedtoequipment,advertising,productdistribution).Youcanthenmoveontothemoretraditionalfinancialstatements:● Historical statementsshouldgobackaboutfiveyearsinmostcases.Ifyourbusinessiscycli-
calinnature,however,youshouldcoveracompletecycle,evenifitmeansdiggingfurtherintothepast.Thereportsshouldincludebalancesheets,incomestatementsandcash-flowstatements.
● Projectionsshouldalsoincludepro-formabalancesheets,incomestatementsandcash-flowstatements.Summaryreportsareacceptableinmostcases.Besuretoincludeprojectionsforatleasttheperiodduringwhichthefundswillbeusedandrepaid.
When a Shorter Proposal Will Do
Usually,youwillneedafull-blown12-pagebusinessplantoensurepropertreatmentonmostfinancingexpeditions.Buttherearetimeswhenalessthoroughtreatmentwillsuffice.Forin-stance,youmayalreadyhaveestablishedacloserelationshipwithyourbankandmerelyneedtopresentadocumentedproposaltotheloancommittee.Or,youmaybeattemptingtoarrangenewfinancingfromaprivateinvestorwhoisalreadyfamiliarwithyourcompany’soperation.Insuchcases,youcanusuallysubstituteasummaryfinancingproposalforaformalbusinessplan.
Asummaryfinancingproposalisaminibusinessplanconsistingofnomorethansixorsevenpages.Thefirstpagecontainstheproposalitself,detailingtheamountofcashneeded,repaymentschedule,collateralandanyotherpertinentdetails.Thesecondpagesummarizeshowthefundswillbeusedandhowyourfirmwillbenefit.Briefly,thissectionsetsforthyourargumentsonwhytheproposalwouldbeagoodloanorinvestment.Thisisfollowedbyatwo-tothree-pageoutlineonyourcompany’shistory,itsproductandmarketingposition,themanagementteamandasummaryofitsprospectsforthefuture.Inshort,thisisacapsuleversionofthedescriptivesectionofaformalbusinessplan.
Mastering Business Finance / 71
Finally,youshouldincludeacondensedbalancesheetandincomestatement,plusayearortwoofprojections.Cash-flowstatementswouldgiveasubstantialboosttoyourargumenthere.
WheretoLookforFundsCompaniesraisemoneyforexpansioninthreeways.First,businessescanuseretainedearnings,whichisthemoneytheyearnthroughtheiroperationsanddonotdistributeasdividendstoshare-holders.Thissimplymeanspayingforanexpansionprojectwiththecashyougeneratethroughprofits,similartotheeverydaypersonalpurchasesyoumake.Thesecondmethodisborrowing,andthethirdisequityfinancing(thesellingofsharestoinvestors).
InternalFinancingYourtopsourceofcapital isyourcompany’sowncash. Itcomesfromsalesandshowsupinprofits.Yet,althoughinternalsourcesareobvious,manyfinancialplannersoverlookthemwhentheyaredevisingcapitalformationschemes.
Many internalfinancing schemesboildown to cashmanagement.Plus, attention to cashmanagementearlyinthefinancialplanningprocesshasvalueevenifyoucan’trelysolelyoninternalsources.Effectivecashmanagementwillhelpconvincelendersandinvestorsthatyoureallyknowhowtorunacompanyandthatyou’lltreattheirmoneywiththerespectitdeserves.
Capitalformationbeginswithyourcompany’scashbudgets.Asexplained,therealaimofcashmanagement is toensureyouhavetheamountofcashyouneed justwhenyouneedit.There’sanotheradvantageofcarefulcashmanagement.Oftentimes,comparingactualcashflowwithyourpredictionscansignalanearlywarningoftheneedtoimprovemanagementcontrols.Youcanavoidcostlymistakesbytakingstepstoheadoffaflowinthewrongdirectionbeforeitbecomesaflood.Somekeystoimprovingyourcashmanagement:● Keepyourmoneyinmoneymarketaccounts.Notonlywillyouearninterest,butyou’llbe
eligibleforbankservices,suchaschecking,atareducedrate.● Useelectronicfundstransferinsteadofcertifiedchecks.Doingsowillloweryourbankcosts
andkeepmoneyworkingaslongaspossible.● Offerdiscountsforcustomerswhopayofftheiraccountsearly.Thiswillreducethecostsyou
incurcarryingreceivablesandwillacceleratecashflow.
Carefullymanageinventory,accountsreceivable,accountspayableandsurpluscash,andthinkofwaystoincreasesales.Thenextthingyouknow,you’vegotthecapitaltomovetothenextstepinyourgrowthplan.Apenny-wiseapproachmaygivemoreobviousbenefitstolargecompanieswithlargeamountsofpennies,butproportionallyitwillworkforsmallercompaniesaswell.
Customers Come FirstMorecompaniesareturningtotheircustomersandvendorsaspotentialsourcesoffinancing.Newtechnologieshavemadesomanybusinessesinterdependentthatthelinesareoftenblurredastowhereonecompany’sfunctionendsandtheotherbegins.AccordingtoRickCanada,direc-torofchangemanagementservicesatMotorola:“Thebestdefinitionofapartnership...iswhenthebuyerandthesellertakeonthecharacteristicsofoneorganization,ratherthantwoseparate,distinctorganizations.”Whenthisoccurs,itoftenforgesatypeofbusinessmarriageorpartner-shipinwhichtwoormorecompaniessharethecosts,risksandprofitsofaparticularventure.
72 / Business Management Daily
MakeYourEmployeesOwnersEmployeestockownershipplans(ESOPs)areemployeetrustfundstowhichanemployercon-tributesstockinthecompanyatnocosttotheemployee.Theyarestructured,however,sothattaxadvantagesallowthecompanytoborrowmoneyatanominalcost.
Untilrecently,ESOPshavebeenusedprimarilytoshoreupshakycompanies.Usually,thetroubledcompanyturnsoverownershiprights(andrisks)toemployeesinthehopeofmotivatingtheworkforceandsecuring“give-backs”onwagesorbenefits.Now,however,manysuccessfulcompaniesareusingESOPsasfundingvehiclesbecauseoftheirsignificanttaxbreaks.
Suppose,forinstance,yourfirmwantstobuyuppartofitsoutstandingstock,butitdoesn’thavethenecessarycashonhand.First,thecompanycreatesanESOP.Next,itborrowsthemoneytobuythesharesandplacesthosesharesintheESOP.Torepaytheloan,thefirmmakescashcon-tributionstotheESOP,andtheESOPpaysthebank.Inthatway,boththeprincipalandinterestontheloanarefullytaxdeductible.Astheloanisrepaid,theESOPstockiscreditedtoaccountsofemployeesparticipatingintheplan.
ESOPsarenotaone-shotdeal.Yearafteryear,acompanycancontributewhatwouldnormallybetaxableprofitstotheESOP,upto25percentofpayroll.However,thecontributionsaremadeinstock—thecompanykeepsthecash.
ESOPscanbevaluablefinancingtoolsformidsizecorporations,particularlycloselyheldfirmsthatmightfinditdifficulttoraisecashthroughnormalchannels.
TheABCsofBankBorrowingAskedwhyherobbedbanks,WillySutton,awilystick-upman,oncesaid,“Becausethat’swherethemoneyis.”Ifyou’reasmallcompany,youprobablydonearlyallyourfinancingthroughbankloans,whichmeansthatyou’llbetakingondebt.Therearesoundreasonsforfinancingthegrowthofyourcompanybyusingdebtratherthantheotherprincipalformoffinancing—sellingsharesinthecompany.
Debt-servicepaymentsareadeductiblebusinessexpense;dividendpaymentsarenot.Whenyou issuenewdebt,you leverageyour company to increaseearningspotential. Issuingnewcommonstockdilutesyourearnings.Mostimportant,newdebtdoesnotweakencontrolofthecompany,aswouldanequityfinancing.
Ifit’sabankyouneed,besuretoshoparoundandknowwhattolookfor.It’simportant,forinstance,tofindoutwhichbanksareinthebestpositiontolendmoney—andmayevenbeunderpressuretomakeloans.Inthisrespect,akeynumbertoknowisthebank’sloan-to-depositratio.Thiswilltellyouwhatpercentageofabank’sdepositsistiedupinloans.Historically,theloan-to-depositratiowasabout60percent.Today,it’smorelike73–75percent.Youcaneasilyobtainthisloananddepositinformationthroughyourstatesuperintendentofbanking.
Getting the most out of your banker:Eventhoughbankssupplywellover90percentofthecapitalneedsofsmallandmidsizefirms,fewbusinesspeopletakethetroubletodevelopasolidrelationshipwiththeirbankers.It’strueinbothyourpersonalfinancesandyourbusinessdealings:Thebesttimetogettoknowyourbankeriswhenyoudon’tneedaloan.Ifyouareinapositionwithinyourcompanytogettoknowthecompany’sbanker,takefulladvantageofthatopportunity.It’sagoodideatoinviteyourbankeronatourofyourfacilities,andkeephiminformedofyourcompany’sprogressbysendingquarterlystatementswithappropriatecommentstohisoffice.
Evenifyoudon’tintendtoborrowfromyourbankintheforeseeablefuture,agoodbankingrelationshipcanhelpyouinmanyotherways.Foronething,abankermakesanexcellentchar-
Mastering Business Finance / 73
acterreference.Assuch,hisendorsementmighthelpinobtainingbettertermsfromsuppliers,equipmentmanufacturersandthelike.
Presenting your case:Byfar,themostfrequentmistakemanagersmakeinapplyingforabankloanistosubmitalaterequestforfunds.Toabanker,anemergencyloanisanathema.Itisanobvioussignofpoorplanning.Nocompetentmanagershouldeverallowaneedthatshouldhavebeenanticipatedtoturnintoafinancialcrisis.Thus,ifyouexpecttohaveanychanceofgettingabankloanapproved,youmustanticipateyourcashneedswellinadvance,toprovideenoughtimeforthebanktoprocessyourapplication.Ittakesatleastthreeweeks,andsometimesmore,toprocessaloan.
Alsomakesurethatyouprovidetheproperinformation,whichissimilartotheingredientsfoundinyourbusinessplan.Thisincludesthefinancial statements(goingbackthreeyearsisthenorm,butsomeinstitutionspreferfiveyears); personal statementsdescribingtheexperienceandcapabilitiesoftopmanagement;anda statement of purposedetailinghowthefundswillbeused,andhowtheywillberepaid.Acash-flowbudgetcoveringthelengthoftheloanishelpful,thoughnotalwaysrequired.
The loan interview:Ifyou’vedoneyourhomework,thebattlewillnearlybewonbythetimeyouappearfortheloaninterview.Inmanyrespects,yourbusinessplanoryoursupportingdocu-mentswilldothetalkingforyou.Nevertheless,youshouldtakethisinterviewseriouslyandbepreparedtoanswerthebanker’squestions,whichwillbesimilartothese:
1. How much?Tellyourbankerexactlyhowmuchmoneyyouneed.Don’tbevague.2. How long?Indicatehowlongthefundswillbeneeded.3. What purpose?Bespecificabouthowyouwillusethemoney.“Generalcorporatepurpose”
isnoanswer.4. How will you repay?Again,bespecific.Ifit’sfromcashflow,bepreparedwithacash-flow
projectionforthedurationoftheloan.5. What if something goes wrong?Prepareyouraceinthehole:anemergencyplantouseif
theloandoesn’tworkout.Youcouldplantosellanasset,borrowelsewhereorhaveanewinvestorontap.Asoundemergencystrategycanbemostconvincing.
Finding the Right Type of Loan
Despitetheintimidatingproceduresinvolvedinnegotiatingaloan,yourbankerwantstolendyoumoney.That’stheinstitution’sbusiness.Hehastobecertain,however,tokeepthebank’smoneyundercontrol.Onewaytoimpressyourbankeristospeakhislanguage;structureyourloanproposalsothatitfitsneatlyintooneofthemanyloancategoriesthatthebankuses.Thereisplentyofroomformaneuveringwithinthesecategories,buttokeepthebankcomfortable,yourloanrequestshouldfitintooneofthefollowinggroups:
Short-term loans:Short-termcreditisthebackboneofcommerce.Businesspeopleuseshort-termloans(definedasloansmaturinginoneyearorless)tofinanceeverythingfrominventorytoemergencies.Hereareafewofthemostcommonshort-termloanclassifications:● Time loans.Forcompanieswithgoodcreditratings,thetimeorcommercialloanisthechief
sourceoffinancing.Itkeepsbookkeepingtoaminimumandcanbeusedforanypurpose,includinginventoryandaccountsreceivable.Timeloansusuallymatureinthreetosixmonthsbutcanberefinancedforlongermaturities.
● Accounts receivable.Inthistypeofloan,thebanklendsyou70–80percentofthevalueofeligiblereceivables.Aschecksinpaymentforreceivablescomein,youforwardthemtothe
74 / Business Management Daily
bank,whichdeductsitsportionanddepositstherestinyouraccount.Interestispaidonlyontheamountoftheloanoutstanding.Tobeeligibleforfinancing,receivablesusuallymustbelessthan60daysold,andyourcustomersmustbecreditworthy.
● Line of credit.Alineofcreditisbyfarthesimplestandmostflexibleshort-termfinancingavailableforabusiness,especiallyasmallone.There’sacatch,though:Creditlinesareusu-allygrantedonlytothemostcreditworthycustomers.
Medium-term loans: Theprincipaldifferencebetweenashort-termandmedium-termloanistheimportanceofcollateral.Medium-termloansareforuptofiveyearsandarenormallyusedtofinanceequipmentpurchasesorplantexpansion.Ingrantingsuchloans,thebankwillusuallyexpectyoutopledgeanassetthatwillgeneratetherevenuesneededtorepaytheloan.
Abankerregardscollateralasasafetyvalve.Althoughyourabilitytorepaytheloanoutofyourcashflowisthekeyfactoringettingtheloanapproved,yourbankwillalsorequestthattheloanbesupportedbycollateral,justincasesomethinggoeswrong.Hereisarundownonsomeofthemostcommonassettypesandhowyourbankislikelytoregardthemascollateral:● Liquid assets.Moneymarketaccounts,savingsdepositsandbankcertificatesofdeposit(CDs)
canbetakenatfacevalue,ascanshort-termU.S.governmentsecuritiessuchasTreasurybills.However,longer-termTreasuryormunicipalbondsaretakenatmarketvalue.Listedstocksandbondsareusuallydiscountedfrommarketvalue,withthediscountrunningasmuchas25percent.
● Accounts receivablecanbringasmuchas60–80percentof facevalue,providedtheyare“eligible.”Thismeansweedingoutolderaccounts,doubtfulaccountsandslowpayers.
● Inventoriesarelessvaluableascollateral,primarilybecausetheyaremoredifficulttosell.Figureonanaverageofapproximately30percentofthecostofrawmaterialsandfinishedgoods.
● Machinery and equipmentaremeasuredbyauctionvalue.Youcanusuallyuse50–70percentoftheauctionvalueofmachineryandequipmentascollateral.
Term loans:Mosttermloansarewrittentocoverthelifeofanassetorforafive-yearperiodwitharefinancingclause.Theyarewrittenfor80–90percentofanasset’stotalcost.Paymentsaremadequarterlyandconsistof equal amountsofprincipalwith interest computedon theoutstandingloanbalance.
Becausesmallcompaniesoftenfindquarterlypaymentsburdensome,manybankswillworkoutascheduleofmonthlypayments.Mostbanksalsowilltailorpaymentstomeetthecompany’sneeds,suchasacceptinglowerpaymentsintheearlyyearsoftheloanandhigherpaymentslater.
Long-term loans: Long-termloans(overfiveyears)havebeenvirtuallynonexistentforthepastseveralyears.Fromabusinessperson’sstandpoint,theinterestrateistoohigh,andthebankishesitanttocommititscapitalforalongtermwheninflationmighterodethevalueoftheassettobefinanced.Whenlong-termloansareused,theyalmostalwaysinvolverealproperty.● Business property mortgages.Inmorestabletimes,commercialandindustrialmortgages
werenotunlikeresidentialmortgages.Theyranforaslongas25yearsandwerepaidoffinmonthlyinstallments.
Nowadays,youmaynotbeable togetamortgage formore thanfive to10years.Thesemortgagesusuallyinvolveequalmonthlyinstallments,withaballoonpaymentattheend.Onlyrarelyisrefinancingguaranteed,althoughmostcompaniescannegotiateanewdealwhentheballoonpaymentisdue.● Real estate loans.Ifyouhavesubstantialequityinyourbuilding,itmaystillbepossibleto
arrangeasecondmortgage.Interestcostscouldbeveryhighinsomeareas,however.Awhole
Mastering Business Finance / 75
newrefinancingpackagemightalsosatisfyyourcashneeds,butyou’llprobablybeswappingalow-costmortgageforahigherone.
Inshort,unlessyouarecertainthatthereturnonyourproposednewinvestmentwillbeveryhigh,youwouldbebetteroffleavingtheequityinyourplantuntapped.
Score Your Loan Worthiness
There’salimittotheamountofdebtanycompanycanhandle.Thus,nomatterhowsmoothyourpresentation,yourbank(oranyotherlender)willalwaysevaluatehowmuchdebtyoucanafford.Ifyouwanttogaugeyourchancesofreceivingafavorablereceptionatabank,thereareacoupleoftechniquesyoucanuse.Lenderstraditionallylookattworatiostotestyourabilitytorepay:
1. Interest coverage ratio:earningsbeforeinterestandtaxesdividedbyinterestcharges.Thisbasicratiodefinesyourabilitytomeetinterestpaymentsontime.Inflationhasledtoalteredstandardsformanyratios,butthisoneremainsunchanged.Youshouldhave$3ofoperatingearningsforeach$1ininterestcharges.
2. Debt-service ratio:Thisratioiscalculatedasfollows:
Earningsbeforeinterestandtaxes Principalpayments 1–taxrate
TheLoanApplication
Alenderwillmakeyoufilloutaloanapplication.Typically,theapplicationasksforagreat deal of information, some of which will be contained in the business plan:
● The loan amount requested.
● How, when and from where it will be repaid.
● Description of collateral.
● Names,personalfinancialstatementsand income tax returns for anyone who will personally guarantee the loan.
● General information about the business: name, addresses, phone numbers, tax ID numbers, year-end statements.
● Type of business and history of the busi-ness.
● Structure, management and ownership, including résumés.
● List of other businesses that the owners control.
● Completeauditedfinancialstatementsfor the last three years, including bal-ance sheets, income statements and projections through the end of the year.
● Cash‑flowprojectionsforthetermofthenote.
● Recent aging of accounts receivable.
● Referencesfromfinancialinstitutionswith which your business has any kind of relationship.
● Customer references.
● Reportonanysignificantdevelopmentsfor the business.
● Any additional material you want to include, such as brochures to help the lender understand the business.
Interestcharges+
76 / Business Management Daily
Principalpaymentsareadjustedforafter-taxearningsbecausetheyarenottaxdeductible.Theinterestcoverageratiosaysnothingaboutyourabilitytomeetdebtrepayments.This
ratiocorrectsthatfailing.Aratioof1iscritical;anythinglessandyourcompanyisindangerofdefault.Tobesafe,aratioof2ormoreisdesirable.
Inadditiontotheseratios,there’satechniquecalledtheZeta scoring system.Thisisapropri-etarycomputermodelusedbybanksandotherinstitutionstomeasureacompany’svulnerabilitytofinancialdifficulties.EvenifyourbankdoesnotusetheZetasystemitself,yourZetascoreshouldgivesomeindicationofhowyoustandaccordingtotraditionalfinancingbenchmarks.Theheartofthesystemisagroupoffinancialratios,eachweightedaccordingtoitsimportanceasanindicatoroffinancialhealth.Aswithallnumericalratingsystems,themodelhasitsflaws.Nevertheless,theZetascoringsystemhasbecomeoneofthemorecommonmethodsofevaluat-ingacompany’sfinancialunderpinnings.
Youshouldencounterlittledifficultyincomputingyourcompany’sZetascoreonyourownbyusingdatafromyourmostrecentfinancialstatements.Herearethekeyelementsandahypo-theticalillustrationofhowtheywereusedbytheXYZMfg.Company:● Working capital.First,divideworkingcapital(currentassetsminuscurrentliabilities)bytotal
assets.Then,toobtaintheproperweight,multiplyby1.2.XYZ’sassetstotal$120million,andworkingcapitalstandsat$24million.Thus,$24milliondividedby$120million=.20.When.20ismultipliedby1.2,theZetafactoris0.24.
● Cumulative profitability.Here,youdivideretainedearningsbytotalassets.Thismeasure-mentisweightedalittlemoreheavily,somultiplytheanswerby1.4.RetainedearningsofXYZamountto$54.4million.TheZetacalculationforthiscomponentbecomes$54.4milliondividedby$120million=0.45x1.4=0.63.
● Return on assets.Thismeasureofprofitabilityisgiventheheaviestweight.Dividepretaxprofitsbytotalassets.Thenmultiplyyouranswerby3.3.Withpretaxprofitsof$28.4million,XYZ’sZetacalculationforreturnonassetsbecomes$28.4milliondividedby$120million=.24x3.3=0.79.
● Return on sales.Here,youmeasurehowmanysalesdollarsaregeneratedbyeachdollarofassets.Dividesalesbytotalassets.Theweightingisneutral,somultiplyby1.0.Salesof$145millionforXYZaredividedby$120million,producingafigureof1.2.Whenmultipliedby1.0,theZetafactorremains1.2.
● Leverage.Thisfinalratioisabitdifferentinthatitattemptstomeasurethevolatilityofyourcompany’scapitalstructure.Divideshareholders’equitybyyourtotaldebt.Thisfinalcom-ponentisnegativelyweighted,somultiplyby0.6.XYZ’sequityof$90.6millionisdividedbyatotaldebtof$33million,producingaratioof2.75.Thisismultipliedby0.6foraZetafactorof1.65.
Toarriveatyourcompany’sZetascore,merelyaddthescoresforeachindividualcomponent.Ifyourfinalscoreis3.0ormore,youareingoodfinancialshape,accordingtotheZetasystem.Ascoreoflessthan2.0indicatesthatsomeproblemsexist,andanythinglessthan1.8placesafirminthehigh-riskcategory.Anegativescoreissupposedtoforeshadowimminentbankruptcy. InXYZ’scase,thefivecomponents,addedtogether,yieldatotalZetascoreof4.51,ormorethanenoughtojustifyaloan.
➤ Observation:Zetascoresareseldomcrucial toabanker’sevaluationofyourcompany.Therearemanyotherfactorsofatleastequalimportance.Nevertheless,ifyoufindthatyourZetascoreisonthelowside,youcanprepareargumentstorefutetheimplications.IfyoufindthatyourZetascoreissatisfactory,youcanciteitasevidenceoffinancialhealth.
Mastering Business Finance / 77
If Your Banker Turns You Down . . .
Mostbusinesspeoplehavebeenturneddownforabusinessloanatleastonceintheircareers,anditcanbeawrenchingexperience.Ifyourloanrequestisrefused,don’tpanic.Yourcompanywillprobablyprosper,evenwithouttheextracash.However,youhavesomeworktodo.
Thefirsttaskistofindoutwhyyouhavebeenturneddown.Askyourbankerdirectly.Askforspecifics;don’tsettleforavagueanswer,suchas“undercapitalization.”Youcan’tcorrectthesituationunlessyouknowwhatiswrong.Mostloanrequestsareturneddownforoneofthefollowingreasons:
1. Poor communication.Ifyouandthebankerdon’thititoff,thechancesforyourloandropprecipitously.Solution:Asktobeservicedbyanotherloanofficer.Youhavearighttoexpectthatthepersonservingyouwillbeempatheticaboutyourproblems.
2. Uncontrolled expansion. Banksshyawayfromacompanywitharevenuegrowthratethatsurpassesitsabilitytofinancenecessaryexpansion.Solution:Ifyouwanttofinanceanexpan-sionprogram,makecertainthatyourbusinessplanincludesafullexplanationofhowyourcompanyexpectstokeeppacewithsalesgrowth.
3. Overly optimistic business plan.Yourbankwillcheckyoursalesandearningsforecastsagainstindustrywideforecastsandmayalsomatchyourprojectionsagainstthoseofacompanyinasimilarbusiness.Ifyourforecastsappeartoooptimistic,yourloanwillprobablybeturneddown.Solution:Keepforecastsrealistic,evenconservative.
4. Past misuse of loan funds.Ifyouusefundsforaprojectnotinyourstatementofpurposeandthebankfindsout,yourchancesofreceivinganotherloanfromthatbankareslim.Solution:Ifcircumstancesbeyondyourcontrolmakeitimpossibletofulfillloanconditions,informyourbankatonce.
5. Rapid inventory buildup.Toabank,asuddensurgeininventoriesmeansoneoftwothings:poorplanningoranunanticipateddropinsales.Ineithercase,thereisreasontoholdoffnewcredit.Solution:Makesureyourinventoriesareinreasonableshapebeforeyouapplyforaloan.Don’texpectthebanktofinanceinventoriesabovetherangeyounormallycarry.
Nobankenjoysturningdownaloanrequest.Apartfromthefactthatthebankmakesmoneybylendingfunds,thebankunderstandablywantstobeviewedfavorablybyitscustomersandprospectivecustomers.Therefore,ifyouareturneddown,youprobablyhavethefullsympathyofyourbankeratthatmoment.Youmightbeabletousethatsympathyasabridgetoyournextmove,byaskingforyourbanker’shelpwithsuchquestionsas:“Whatwouldyoudoifyouwereme?”or“WhatsourceshouldItrynow?”
LoanGuaranteesFromtheSBAIfyouareturneddownforaloanbyyourbanker,youmayapplyforaloanguaranteebytheSmallBusinessAdministration(SBA).Providedyoumeetcertainriskrequirements,theSBAcanguaranteetheloan.(Incitieswithapopulationof200,000ormore,youmustbeturneddownbytwobanksbeforeapplyingforanSBAloan.)Ifyouhaveagoodrelationshipwithyourbank,itwillprocessyourloanthroughtheSBA.Thiswillrequireagreatdealofdocumentation,includingtheusualbusinessfinancialstatements,plusthefollowing:acurrent personal financial statementfromallholdersof20percentormoreofthecompany’scommonstock;a business plancoveringtheperiodoftheloan;andalist of all collateral,includingtheestimatedmarketvalueofeachitem.
78 / Business Management Daily
Inthepast,theattractivenessofSBA-guaranteedloanshaddimmedbecauseoftheseeminglyinterminableamountofredtapeandthetimeittooktogettheloanapproved.TheSBAhasbecomemoreinnovativeinattemptingtoreducethatleadtime.Inparticular,anewprogram,dubbedthePreferredLendersProgram(PLP),cancutprocessingdelaysdramatically.PLPloansfrequentlycanbeprocessedintwotothreedays.
How PLP Works
OnereasonforthisfasterprocessingisthatthePreferredLendersProgramturnsovermostofthepaperworktothebanklender.WhereasinprioryearstheprincipalresponsibilityforapprovalrestedwiththeSBA,thePLPtransfersthatresponsibilitytothebankmakingtheloan.Participat-inglenderscandetermineeligibility,creditworthinessandloanstructuring,aswellasmakeotherdecisionsontheirown,withoutpriorrevieworconsentbytheSBA.
UnderthePreferredLendersProgram,theamountof loanguaranteedbytheSBAcannotexceed75percent.Thiscompareswithaguaranteerateof90percentonpreviousSBAprograms.
IfyourareaisnotservedbyparticipatingPLPlenders,keepinmindthattheSBAstillcontinuestooperateitsCertifiedLendersProgram(CLP).UndertheCLP,participatinglenderstrainedinhandlingSBAloanapplicationscanobtainadecisionandloandocumentpackagefromtheSBAwithinthreeworkingdays.Formoreinformationabouttheseandotherprograms,contactyourlocalSBAofficeorvisitwww.sba.gov.
LoansFromCommercialFinanceCompaniesIfyouhaverecentlybeenturneddownforaloanbyabank,youmightreceiveawarmerwelcomeatacommercialfinancecompany.Indeed,manybanks,inrejectingaloanproposal,willreferacustomertoacommercialfinancesubsidiary.
Commercialfinancecompaniesuseaportionofacompany’sassetsascollateralforbusinessloans.Theirlendingstandardsarenormallymoreliberalthanthoseofbanks.Rates,however,aregenerallyhigherandvarywiththetypeofcollateralandlengthoftheloan.Generally,ratesvaryfrom3percentto6percentaboveprimeonloansmaturingintwoto15years.Thetypesofloansinclude:● Inventory loans.Inthistypeofloan,youuseyourinventoryascollateral.Thelenderwill
advancefundsatacertainpercentageofyoureligibleinventories.Thereisnostandardper-centage,butbecauseinventoriesarevaluedatdistressor“knock-down”prices,thevaluationisalwaysconservative.Youcancountonfrom25percentto50percentofeligibleinventories.
Yousupplyaregularscheduleofinventoriestothelender,andthetotalamountoftheloanisadjustedasinventoriesfluctuate.Generally,freelytradedcommoditiesreceivethehighestadvancesinaninventoryloan,whiledifficult-to-sell,work-in-processinventoriesreceivethelowestadvances.● Equipment loans.With these,youfinancenewequipmentbyborrowingagainstexisting
equipment.Machinery,rollingstock(vehicles)andevencomputerscanbeusedascollateral.Theequipmentmusthaveafirmresalevalue.Obsolete,rareorunusualequipmentcannotbeusedascollateral.
Afterappraisalbyanindependentparty,thecompanybeginstoworkouttheloanterms,whichdependprincipallyontheexpectedusefullifeoftheequipmentandthefinancialcondi-tionoftheborrower.Frequently,acompanycanarrangealoantocoverevenadownpaymentonsomenewequipment.
Mastering Business Finance / 79
● Receivable loans.Foratime,banksweretakingonagrowingportionofreceivablesfinanc-ing.With tighter credit conditions,more recent receivables-financing activity tends tobeconcentratedincommercialfinancecompanies.Relativelyyoungreceivablesaccountsfromcreditworthycustomersqualifyforloans.Youarechargedinterestonlyontheamountdue.
➤ Observation:Mostasset-basedfinancingcompanieshaveminimumloanprovisions,usuallyofabout$100,000.Themoreyouborrow,themorefavorabletherate.Bepreparedtoguaranteetheloanpersonally:Apersonalguaranteeisarequirementwithacommercialfinancecompany.
Using a FactorIfyourcompanyneedsfinancingtobuildupinventoriesinadvanceofheavyshippingdates,orhastroublehandlingswollenaccountsreceivableafterapeakseason,afactormightbeabletoputyourbusinessonamoreevenkeel.
Inafactoringarrangement,yourcompanyactuallysellsitsreceivablestothefactor,whichthenassumes all credit riskswithout recourse. Factoringhas longbeena commonbusinesspracticeinthetextileandapparelindustries,butithasbeenslowtospreadtootherindustries.Thisisbecausefactorshavehistoricallyadoptedaninsularattitude,andbecausecustomersintheindustrieswherefactoringisnotcommonaresometimesdisturbedathavingtheiraccountsassignedtothirdparties.However,competitionhasheatedupamongfactors,andmanyarenowseekingclientsoutsidetheirtraditionalindustries.
Alongwiththischangeinattitudehascomeavarietyofnewfactoringservicesthatcanbespeciallytailoredtoavarietyofneeds.Mostfactorscurrentlyprovidethefollowingservices:● Maturity factoring.Inthistraditionalformoffactoring,youselltheaccountsreceivabletothe
factorandyoureceiveyourmoneywhentheinvoicematures(usually30days).Thecustomerisnotifiedthatheorsheistoforwardpaymentdirectlytothefactor,whichhandlesallthecollectionandbookkeepingchores.
● Nonnotification factoring.Underthisarrangement,yourcompanyhandlesthebookkeepingandcollectspayments.Yougetabreakonthefees,andyourcustomerdoesn’thavetoknowaboutthefactoringarrangement.
Factoringhasabigadvantageoveraccounts-receivableloansinthatyoureceivethefullamountofyourreceivablesastheycomedue,ratherthanthe70–80percentthatyougetfromabankloan.Also,factorsoffercashadvancesonreceivablesnotyetdue.Theseareessentiallyloansthatthecompanyusestocoverpeakinventorybuildupsinanticipationofabulgeinreceivables.Rateschargedonadvancesusuallyvarybetween1percentand3percentoverprime.
Can you use a factor?Ifyoubelievethatthetime,talentandresourcesnowbeingdirectedtocreditoperationsmightbebetterspentonsalesorproduction,youcanprobablyusetheservicesofafactor.Thisisparticularlytrueifyouperiodicallyneedadditionalcashtoeaseseasonalorcyclicalfinancialobligations.Keepinmindthatfactoringfeesarerelativelyhighandtypicallyrunbetween1percentand2percentoftheamountfactored.Againstthis,however,youmaybeabletocutdown,oreveneliminate,yourcreditdepartment.
Itisunlikelythatnonfinancialmanagerswillgetinvolvedinmoresophisticatedfinancingmaneuvers,butthefollowingsectionbrieflyexploresotherfinancingtechniquesthatyoumayencounterinyourjob.
80 / Business Management Daily
BondFinancingBondsareactuallyloansthatpeople,likeyouandme,maketocompanies.Inexchangefortheloanmoney,companies issuebonds.Thetermsoftheloanaresetout inawrittenagreementcalledthebond indenture.Thisstipulatestheinterestratethatwillbepaidtobondholdersandwhentheprincipalwillberepaid.Italsodesignatesatrustee,whoisresponsibleforseeingthatthetermsoftheagreementaremet.
Illustration:A$1,000bondmayguaranteetopay10percentinterest(oftenreferredtoasa 10percentcoupon rate)annuallyover10years.Theinterestispaidatspecifictimes,usuallyeverysixmonths.Attheendofthe10-yearperiod(thematurity date)thecompanyrepaystheinvestortheoriginal$1,000(theprincipal).
Althoughyourfirmmaydecidetoissuebondsonitsown,it’smorelikelythatmanagementwilluseanoutsideinvestmentbankertounderwritethebondoffering.Likestockofferings,thesellingorissuingofbondsisheavilyregulatedbytheSecuritiesandExchangeCommission,whichrequiresacompanytomeetanumberoflegalrequirements.Thus,it’softenmucheasierforacompanytoturnthe“floating”ofbondsovertoaprofessionalinvestmentbanker,especiallyifit’sthefirsttimeyourfirmisgoingintothebondmarket.
An investmentbankerbuys thecompany’sbond issueand thenresells it to thepublic; it absorbsthelossifthereareanybondsthatitcannotresell.Foritsservices,theinvestmentbankerreceivesafee.Keepinmindthatbondinterestispaidfrompretaxdollars,andthatbondholdersarecreditorsofyourfirm.
Thereareallsortsofbonds,buthereareafewofthemorecommontypes:● Mortgage bonds.Asthenameindicates,thecompanypledgesascollateralspecificfixedassets,
suchasabuilding.Generally,theassetisofgreatervaluethanthevalueofthebondsissued.Thisensuresthat,incaseofabonddefault,theinvestorshavesufficientfinancialprotectionthroughresaleoftheasset.
● Collateral trust bonds.Inthisvariationofmortgagebonds,theassetsusedascollateralarestocksandbondsofothercompaniesinwhichyourfirmholdsaninterest.
● Equipment trust certificates.Thistypeoffinancingisfavoredbyrailroadsandairlinestomakemajorequipmentpurchases.Thecompanysellsthecertificatestoinvestors,andtheproceedsareusedtopayfortheequipment,suchasrailroadcarsorairplanes.Thetrusteetakestitletotheequipment.Therailroadorairlinethenpaystheperiodicinterestandtheprincipaltotheinvestorsoveraperiodoftime,say15years.Whenallthecertificatesarefinallypaidoff,titlepassesfromthetrusteetotheairlineorrailroad.
● Debentures.Theseare,ineffect,unsecuredbonds.Asanissuingcompany,yousimplypromisetopayinterestonthedebentureandrepayitinthesamewayyouwouldabond,exceptthatyoudon’tpledgeanyassets.Becausethereisn’tanycollateral,investorsassumeagreaterriskandrequireahigherinterestratethantheywouldonasecuredbond.
Inanothervariation,yourcompanymaywanttoaddabitofincentivetoinvestorsbymakingyourbondsanddebenturesconvertible.Thismeansthepurchaserofyourconvertiblebondsordebentureshastheoptionofexchangingthemforaspecifiednumberofsharesofyourcommonstock.Theattractionhereisthatthepriceofyourstockmayincrease,soitpaystheinvestortoconverttostock.Ifthisoccurs,yourcompanynolongerhastopayinterestortheprincipal.
Yourcompanymayemployotherfactorsthatareattractivetotheprospectivebondholder,aswellasyourcompany.Forexample,thecompanymaydevelopasinking fund,whichmeans
Mastering Business Finance / 81
thefirmsetsasidespecifiedamountstoprovideforthegradualretirement(repurchase)ofpartofthebondissue.Thisprovidesaddedprotectionforbondholdersbecausereducingtheamountofoutstandingbondslessenstheriskofadefault.
Acompanycanalsoincludeacall featureforgreaterfinancingflexibility.Thissimplymeansthatthecompanyreservestherighttobuybackthebondataspecifieddatebeforethebondfallsdue.Thecallpriceisgreaterthantheprincipalamountandgenerallydecreasesasthebondap-proachesitsmaturitydate.Companiescanexercisethecallfeature,forexample,whenmarketinterestratesdrop,allowingthefirmtorepaythebondholderandthenrefinanceatalowerin-terestrate.Althoughthecallfeatureisattractiveforthecompany,it’snotanadvantageforthebondholderbecauseheorsheisgivingupthehigherinterestpaymentsofthebond.Asapartialremedy,bondswithcallfeaturestypicallycarryahigherinterestrate.
RaisingEquityCapitalEquitycapitalenjoysonlyonesignificantadvantageoverborrowedcapital,butforsomethisadvantageoutweighsalltheotherdrawbacks:Equitycapitalispermanentcapital;itneednoteverberepaid.
However,wheneveryourcompanyacceptsthispermanentcapital,itwill,ineffect,alsobeacceptingapartnerwhowillshareinthefortunesofthefirmfromthereon.Therefore,beforemanagementdecidesthattheequitymarketisagoodidea,itshouldfirstanswerafundamentalquestion: Is thepermanentnatureof thenewcapital thatwillberaisedworththedilutionofcontrolthatmaygowithit?
Therearefourdistinctfinancingmethods.Managementcan(1)seekoutaventurecapitalist;(2)raisethemoneythroughprivateinvestors;(3)tryprivateplacementthroughaninstitutionorinvestmentbankers;or(4)planapublicoffering.Forthenonfinancialmanagerwhoisconsideringstartingabusinessofherown,thesecondsectionisparticularlyimportant:Privateinvestmentfundshavebeenthesourceofmoneyforhundredsofsuccessfulstart-ups.
How to Attract a Venture Capitalist
Thefirstwaytoraiseequitycapitalisthroughaventure capitalist,whoinvestsinnewcompanies.Thebestwaytoattractaventurecapitalististohavea“friendincourt.”Ifyouknowsomeonewhohashaddealingswithaventurecapitalist,hisintroductionwillhelp.Still,arecentsurveyindicatedthatwellover80percentofallventurecapitalfirmshavenoparticularpreferenceonhowtheyareapproached.
Holdingtheattentionofaventurecapitalistmightbeanothermatter,however.Venturecapi-talfirmsmaintainstrictinvestmentstandards.Theyrequirethesameinformationasabankerwould—andmore. Ifyouare interested in establishing sucha relationship,hereareways toimprovetheodds:
1. Growth.Bereadytodemonstratehowyoucanincreaseyourrevenuebyabout$15millionand/oryourprofitsby$1millionwithin thenext three tofiveyears.Otherwise,venturecapitalistsareunlikelytoshowmuchinterest.
2. Product line.Mostventurecapitalfirmsconcentrateonindustriesinwhichtheyhaveac-quiredacertainamountofexpertise,orthosethatpromiseunusualgrowth.Ifyoucanlocateaventurecapitalfirmthatknowsyourindustry,yourchanceswillsignificantlyimprove.
3. Your management team.Venture capitalists tend to avoida “one-man show,”nomatterhowexcitingtheprospectsmaybe.Firmsthatcandemonstratemanagementcapabilityina
82 / Business Management Daily
numberofareas,suchasfinance,marketing,productionandadministration,generallyreceivepreferentialtreatment.
4. Long-term planning.It’sessentialthatyoudrawupasoundcorporateplanforatleastfiveyears,includingcash-flowandincomeassumptions,beforediscussionswithaventurecapital-istbegin.Givesomethoughttoeventualcorporategoals,suchaspublicownership,amergerorotherpossibilitiesthatwillenabletheventurecapitalisttowithdrawfromthefirminfivetosevenyears.
➤ Observation:Ifyourfirmdoesn’tmeetthestandardsdiscussedabove,youwillprobablybewastingyourtimetryingtocourtaventurecapitalist.Althoughfundinghasincreaseddra-maticallyinthepastseveralyears,venturecapitalistsstillacceptonlyabout5percentofthedealsofferedtothem.
Evaluating a Venture Capitalist
Youcanavoidanuncomfortable,time-wastingrelationshipwithaventurecapitalistbydoingalittleevaluatingonyourown.Aventurecapitalistmayaskforupto60percentofyourcompany,sotheassociationshouldhaveconcreterewardsforyou.Herearesomeguidelinestofollowinyourevaluation:● Checkouthowaventurecapitalist’sclientsfaredinthepast.● Determinewhethertheventurecapitalisthelpsherclientswithadditionalfinancingif it’s
necessary.Youwillprobablyneedadditionalfinancingforyourfirminthefutureifthefirstoneissuccessful.
● Agreeonwhatrole—activeparticipantorpassiveinvestor—theventurecapitalistwillplayinyourfirm.Youmightpreferthathemerelysitonthesidelinesafterthedealismade,oryoumightwantactiveinvolvementinmanagement.Whateveryourwishes,makesuretheycoincidewiththoseoftheventurecapitalist.
● Findoutwhatkindofreputationtheventurecapitalistenjoysinthebusinesscommunity.Youwillwanttoknowwhetherthereputationwillhelporhinderyouinattractingotherfinancingsources.
DealingWithanSBICSmallbusinessinvestmentcompanies(SBICs),aspecializedformofventurecapitalfirms,havebecomeanimportantsourceofcapital.SBICsarelicensedbythefederalgovernmenttofillafinanc-inggapforsmallbusiness.SBICscanborrowuptofourtimestheirprivatecapitalpositionfromtheU.S.governmentatfavorableborrowingrates.MostSBICsattempttocoveronlyoperatingexpensesonloans,withprofitscomingfromequityparticipation.Thus,theinterest-ratespreadisnarrow.Often,aborrowerfromanSBICpaysnomorethanone-fourthof1percentovertheSBIC’scostoffunds.Moreover,becauseanSBICdoescoveroperatingexpensesontheloanportionofitsportfolio,itcanaffordtoloweritssightsonexpectedreturnsfromequityparticipations.Forthisreason,thetermsofanequitydealwithanSBICareusuallymorefavorableforyouthanwouldbepossiblewithotherventurecapitalists.Hereareafewadditionaldetails:
Length of loan.Bylaw,thetermofallSBICloansmustbebetweenfiveand15years.Asapracticalmatter,however,fewSBICloansaremadeformorethan10years.MostSBICspreferloansthatmatureinaboutsevenyears.
Equity participation.Usually,anSBICmakesaconvertible loan,underwhichitreservestherighttoconverttheloantocommonstockatspecified,prenegotiatedtimes.Amountsofcommon
Mastering Business Finance / 83
stockavailableforconversionandtheconversiontermswill,ofcourse,dependonthesizeoftheloanandtheinherentriskinyourcompany.Innocase,however,cantheSBICassumecontrolofacompany—it’sprohibitedbylawfromdoingso.Aswithventurecapitalcompanies,mostSBICswilloffermanagementassistance,shouldyouneedit.
Cashing in.Uponconversion,theSBICmightdisposeofthestockinanumberofways,in-cludingapublicoffering,aprivatesaleorpossiblyevensellingthestockbacktothecompany.Whateverthecase,youwillusuallyexplorethealternativesthoroughlyduringnegotiations.
➤ Observation:TogetstartedwithanSBICfinancing,youwillneedadetailedbusinessplan.Also,lookaroundforanSBICthathassomefamiliaritywithyourindustryanditsproblems.Finally,someSBICsprefertoconcentrateonlyonfast-growingcompanies,whileothersaresatis-fiedwithcompaniesgrowingatamoredeliberatepace.
VirtuallyallSBICsaremembersoftheSmallBusinessInvestorAlliance,formerlyknownastheNationalAssociationofSmallBusinessInvestmentCompanies.ThisorganizationcantellyouallyouwanttoknowaboutSBICs,includingthelocationofthosenearestyou.Formoreinforma-tion,visitwww.nasbic.org.
The Role of the Private Investor
Forsmall,closelyheldfirms,privateinvestorsarebyfartheirmostimportantsourceofequitycapital.Thisequitycantakeanumberofforms.Usually,equitycapitaldenotescommonstock,butmanyprivatefinancingdealsinvolvepreferredstock,debenturesorevenwarrantsthatareconvertibleintocommonstock.Thus,whileanownershipinterestisalmostalwaysinvolved,itneednotstartoutwithcommonstock.
Don’texpectaprivateinvestortoacceptapassiveroleinthefirm.Theyarealmostalwaysactiveinvestorslookingtocontributemorethancapital.Usually,aspartoftheinvestmentagree-ment,theyactasconsultantsorserveonyourboardofdirectors.Thus,inasearchforinvestors,managersshouldattempttoidentifythoseinvestorswithexperienceandskillsthatcancontributetothecompany’sprogress.
Asarule,investorsincloselyheldfirmsarewillingtoacceptagreaterdegreeofriskthaninvestorsinpubliccompanies.Inreturn,theyexpecttoreceivehigherrewards.Inasense,then,youarebuyingcapitalratherthansellingequity.Therewardsthatyouarewillingtograntto yourinvestorsare,ineffect,yourcostofcapital.Therefore,thehighertherisks,thegreaterthecapitalcosts.Obviously,therecanbenohard-and-fastrulesfordeterminingtheextentofthereturnsyoumustoffertoattractprivateinvestors,buttherearesomebroadguidelinesforestablishingpossibleranges.Forinstance,inastart-upsituation,investorsusuallyexpecttoearnabout10timestheirinvestmentinfiveyears,acompoundannualreturnof60percentperyear.
Privateinvestorsinfledglingfirmsusuallyexpecttoearnaboutsixtimestheirinvestmentinfiveyears,astill-highannualcompoundreturnof43percent.Arelativelyyoungfirmwouldhavetoofferprivateinvestorsthechancetoquadrupletheirmoneyinfiveyearstoattractcapital,andevenanestablishedfirmwouldneedtoofferthemtheopportunitytotripletheirmoneyinfiveyears.Thatworksouttocompoundannualreturnsof38percentand25percent,respectively.
➤ Observation:Expensiveastheyseem,expectationsforprivateinvestors,eveninhigh-risk,early-stagecompanies,aresignificantlylowerthanthoseforprofessionalventurecapitalfirms.Inpart,thisseemingdiscrepancystemsfromthe“not-for-profit-only”characteristicofmanyprivateinvestors.Inmostinstances,privateinvestorsbackcompaniespartlyfornoneconomicreasons,suchasachievingaworthwhilesocialbenefit,helpingafriendorfulfillingacommunityneed.
Privateinvestorstendtobemuchlessformalthantheirprofessionalcounterparts.Still,onaver-age,theyturndowntwooutofeverythreedealsofferedtothem.Youcanimproveyourchancesofmakingafavorableimpressiononprivateinvestorsbyfollowingtheseimportantguidelines:
84 / Business Management Daily
● Be specific.Putyourproposalinwriting.Don’texpecttowingitsimplybecausethepotentialinvestorisanindividualorafriend,ratherthananinstitution.Mostprivateinvestorsrequireawell-definedbusinessplan.Evenwhereabusinessplanisnotnecessary,youshoulddrawupawell-thought-outfinancingproposal.
● Be realistic.Thisincludesanobjectiveappraisaloftheprospectsandproblemsfacingyourcompany,andtherisksandpotentialrewardsintheinvestmentitself.Anyattempttominimizerisksorproblemswillalmostcertainlycausetheinvestortobackoff.
● Discuss your management team.Inreviewingasmallcompany,nothingismoreimpressivetoapotentialinvestorthanadedicated,competentmanagementteam.Makesureyoudem-onstratethattopotentialinvestors.
Theprimaryreasonfortheincreasedriskincurredbyaprivateinvestoristhelackofliquidityintheinvestment.Inotherwords,itcanbedifficulttofindabuyerforthestockofacloselyheldfirm,particularlyforaminorityinterestinthatfirm.Therefore,youwillprobablyneedtoofferanexitformula.Usually,thisinvolvestherighttotenderthestocktothecompanyataspecifieddateandatapricerelatedtobookvalue,cashfloworearnings.Anothercommonexitformulasetsasideanagreed-onpercentageofearningstopurchaseasegmentofsecuritiesheldbytheinvestorataprearrangedprice.
➤ Observation:Whennegotiatinganexitformula,rememberthatprivateinvestorsnormallyhavemuchlongertimehorizonsthanthethreetofiveyearsfavoredbyventurecapitalists.Onerecentpolldisclosedthatnearly25percentofallprivateinvestorseitherhadnotimepreferenceorexpectedtoholdtheirinvestmentsformorethan10years.
Howdoyoufindasuitableprivateinvestor?Thiscanbeathornyproblem:Thereisn’texactlyareferralservicegearedtowardputtingpotentialprivateinvestorsintouchwithcompaniesseek-ingequitycapital.Tolocateprospectiveinvestors,youwillbeforcedtobuildyourownnetwork.
Yourmostfruitfulsourceofinformationwillprobablybeyourfriendsandbusinessassociates.Investmentbankersareanothercommonsource.Yourotherprofessionaladvisers, suchasac-countants,lawyersandbankers,maybehelpful.Finally,besuretoinvestigateanyventurecapitalclubsinyourarea,aswellasbusinessandcommunityassociations.(Note:Venturecapitalclubsaregroupsofindividualinvestors,andshouldnotbeconfusedwithventurecapitalfirms.)Commu-nityassociationscanbeparticularlyimportantbecauseprivateinvestorstendtoconcentrateoncompaniesintheirgeographicareassothattheycanmaintainclosecontactwiththeirinvestment.
Regulation D Private Placement
Smallandmidsizecompaniesareincreasinglyusingprivateplacementsasfund-raisingvehicles,thankstoa1982streamliningoftherulesknownasRegulationD.Inaprivateplacement,stocksorbondsaresolddirectlytoaninstitutionalinvestororasmallgroupofinstitutionalinvestors.
RegulationDisspecificallydirectedtowardopeningupthehugeprivateplacementmarket.Inseveralways,theregulationcanhelpasmallbusinessraisecapitalthroughaprivateplacement.First,RegulationDincreasestheamountofcapitalthatcanberaisedundervariouscategories.Underthesmallestclassification(Rule504),youcanraise$500,000in12monthsversus$100,000undertheformerrule.Amiddlecategory,dubbedRule505,allowsyoutoraise$5millionin12monthscomparedwithapreviouslimitof$2millioninsixmonths.Inaddition,thereisanun-limitedcategorydubbedRule506.
Second,paperworkhasbeencutdrastically.TherearenospecificdisclosurerequirementsunderRule504.Youneedtocomplyonlywithantifraudprovisions.Thisessentiallymeansthatyoumustgiveinvestorsanaccuratepictureofyourcompanywithnomaterialomissionsinyourofferingmemorandum.
Mastering Business Finance / 85
Third,underRule504youcanchoosefromanunlimitednumberofinvestors.Previousregu-lationsplacedalimitof100investorsperoffering.
Finally,tostimulateactivity,RegulationDallowsbroker-dealerstochargeacommissionforhelpingarrangeprivateplacements.Evenwiththecommissionruling,expensesforRegulationDofferingsinthepasthaverunfrom1percentto5percent.That’swellbelowthe13percentcommonlyassociatedwithpublicstockofferings.
How much help will you need for private placements?Ifyou’reconsideringprivateplace-ment,talktoyourlawyerfirst.Hecanbringyouuptodateonyourstate’sfilingrequirements,whichmayormaynotbeasliberalastheSEC’srules.Ifyouhaveaccesstocapitalsourcesinyourarea,youcanprobablyarrangeyourprivateplacementwithoutengagingtheservicesofabroker-dealer.Byallindications,alargeportionofRule504offeringsarecompletedwithouttheservicesofabroker.Inmostcases,theofferingcompany’slawyeroraccountantactsasanintermediary.
Ifyou’reconsideringraisingfundsintheprivateplacementmarket,insurersareanexcel-lentsourceofcapital.Thesecompaniesareincreasinglyactiveinworkingwithsmallbusinesses.Regionalinsurerssometimesloanamountsaslowas$250,000.
Therearemanypotentialadvantagestoworkingwithinsurancecompanies:● Potential for lower rates. Insurersareinterestedprimarilyinlong-termarrangements.Almost
allspeakof“relationshipfinancing,”whichreferstorecurringdealsbetweenacompanyandtheinsurerovermanyyears,ratherthanaone-shotdeal.
Therefore,theyareinclinedtobelessconcernedwithshort-terminteresttrendsthanaremanybankers.Thismeansinsurancefirmswilloftengrantclientsmorefavorabletermsonshort-andmedium-termloansifthiswillhelpthemnaildownlong-termbusiness.● Flexibility.Insurancecompanieswillarrangestraightloans,equityfinancingorthehybrid
deals(debtplusequityfinancing)thathavebecomepopularrecently.Keepinmind,though,thatallinsurancecompaniesconducttheirowncreditchecks.Mostwillconsiderdealsonlyifthefinancesofthepotentialcustomerareregardedas“investmentgrade”(BBBorbetter)byaratingservice.Thismeansthatyourfinancesmustbeingoodshape.
➤ Observation:Ifthereisadisadvantagetoworkingwithaninsurancecompany,it’sfindingtherightfitbetweenyourcompany’sfinancingneedsandtheinsurancecompany’sinvestmentpolicy.Someinsurers,forexample,specializeincertainindustries.Somerequireanintroductionthroughanadviser,suchasaninvestmentbanker.Everyinsurancecompany’sinvestmentstrategyisuniquetosomedegree,soyoumayhavetodosomehunting.Yetthesearchcanbeworthwhile.Looktothemajorinsurancecompaniesforthistypeoffinancing,suchasNationwide,Prudential,AetnaLifeandCasualty,TransamericaandTravelers.
Raising Capital Through a Public Stock Offering
Apublicstockofferingisprobablythemostcomplicatedofthefourwaystoraiseequitycapital.UsingthismethodmeansgeneratingscadsofpaperworktosatisfySECrules.Withthatinmind,herearecapsuledescriptionsofthefourtypesofpublicstockregistrationopentoyourcompany:
S-1 offerings.ThisisthegeneralfilingregistrationrequiredbytheSECandisrarelysuitableforsmallercompanies.Itrequiresmaximumdisclosureforboththeofferingandlaterstatements.Thiscanbeextremelydemandingandcostly.
➤ Recommendation:S-1registrationsshouldbeusedonlybylargercompaniesthathavethefinancialresourcesandthestafftocompletetheformsinvolved.Thereasonisverysimple:S-1registrationscancostupwardsof$300,000,puttingthemoutofreachofmostsmallcompanies.
86 / Business Management Daily
S-2 offerings.Inessence,thisisanS-1offeringdesignedforcompanieswithalimitedhistory:thatis,nosubstantialsalesandearningsforthepastfiveyears.Forsuchfirms,theSECrequirespublishingdetailedinformationontheuseoftheproceedsandissuingvoluminousreportsonthecredibilityandintegrityoftheprincipals.
S-18 offerings.TheS-18offeringisgearedtowardsmallbusinessesthatneedtoraisesubstantialamountsofmoney(upto$5million).ThekeyisthatS-18offeringsareprocessedbyregionalSECoffices,andthereisnoneedtofilewiththeSEC’sWashingtonheadquarters.Thiscutsdownthecostsignificantly.S-18scanbebroughttomarketfor$100,000orless.CriteriaforanS-18offeringinclude:(1)theofferingmustbeforcash;(2)thecompanymustbeincorporatedintheUnitedStatesorCanada;and(3)thefirmmaynotbeaninvestmentcompanyorlimitedpartnership.
Regulation A offerings.Thistypeisdesignedspecificallyforsmallcompaniesandisexemptfrommanyofthefilingrequirements.Toqualify,yourcompanycannothavemorethan$1millioninassetsor500shareholders.Nomorethan$1.5millioncanberaised.SometimesRegulationAofferingscanbebroughttomarketforaslittleas$50,000.
➤ Observation:Thefilingofaregistrationstatementforanewpubliccommonstockofferinginvolvesagreatdealofredtape,withthecostsbornebythecompany.Someoftheindividualcostsinvolvedareasfollows:thetimemanagersmustdevotetopreparingaprospectus;yourownlawyer’sandtheunderwriter’slawyer’sfees;printingcosts,includingtheprospectusandregistrationstatement;registrationcostsforeverystateinwhichthestockistobesold;accountingfees;SECfees;registrationandtransferfees;andfederalissueandtransfertaxes(ifany).
Addtotheseitemsthesellingcommission,andthetotalcostbecomessignificant.Arecentsurveyindicatesthatthecostoffloatingacommonstockissueamounted,onaverage,tonearly13percentoftheproceeds.Keepinmindthatthisisforanaverageoffering.Withouteconomiesofscale,costsforsmallerofferingsrunrelativelyhigher.
Other Methods of FinancingInadditiontothemoretraditionalwaysofraisingcapitalthroughbankloansorstockandbondofferings,thereareanumberoflesser-knownmethods,manyofwhicharesimplyvariationsofthetraditionalones.
A Look at Leasing
Bydefinition,youmaywonderhowleasingcouldbeincludedinadiscussiononsourcesoffi-nancing.Afterall,aleaseisanagreement(contract)conveyingtoabusiness(thelessee)therighttousespecifiedproperty,plantorequipmentownedbyanotherparty(thelessor)forastatedperiodoftime.
Althoughleasingmaynottechnicallybeasourceofcapital,itdoesmakeadditionalcapitalavailabletoacompanybypermittingthefirmtofinance100percentoftheacquisitioncostofanasset,whereasatypicalequipmentloanmayrequirea20percentto30percentdownpayment.Similarly,deliveryandinstallationcharges,certaintaxes, insurance, legalandclericalcostsofarrangingthelease,andmaintenanceexpensesareamongtheothercostelementsthatmaybeincorporatedintotherentalinstallmentsandthusfinancedovertheleaseterm.
EventhoughtheTaxReformActof1986increasedtheafter-taxcostofleasing,itisstilloneofthefewpotentialsourcesofno-money-down,fixed-ratefinancing.Itconservescashandon-the-bookborrowingcapacity(becauseleasesarenotrecordedasaliabilityonthebalancesheet),andittransferssomeoftherisksofequipmentobsolescencetothelessor.Companieswithheavydebtburdens—oftenfromleveragedbuyouts—areturningincreasinglytoleasingasawaytofinancenewequipment.
Mastering Business Finance / 87
Althoughthetaxactmayhaveincreasedthecosts,therearetwokeyfactorsthatmanycom-paniesstillaren’tconsideringintheirbuy-versus-leasedecisionmaking:● The repeal of the investment tax creditandthelengtheningofdepreciationschedulesfor
someequipmenthaveincreasedthecostofbuyingmorethantheyhavethecostofleasinginmanycases.Leaseonacase-by-casebasis.
● The act established the alternative minimum tax (AMT),whichimposesa20percenttaxonmanycommontaxdeductionsdesignatedas“taxpreferenceitems.”Theideawastomakesurecompaniescouldn’thavesomanydeductionsthattheywouldenduppayingnotaxes.
Whatissignificantintheleasingarenaisthataccelerateddepreciation—abigreasoninthepastforbuyinganasset—isamongthosetaxpreferenceitems.However,ifyourcompanyissub-jecttoAMTanditleases,youcandeducttherentorleasepaymentsasexpensesforbothregulartaxandAMTpurposes.
Don’t Forget Development Corporations
WhataboutthoseLDCs,CDCsandBDOs?Ineachcase,theDinthemiddlestandsfor“develop-ment.”Originally,theseorganizationswereformedtoactasaclearinghouse,matchingacompanyinneedoffundswithapotentialinvestor.Somenowgoabitfurther,butcommunitydevelopmentremainstheirchiefaim.Here’sabrieflookateachone:
Local development corporations (LDCs).Usually, anLDC isaprivately sponsoredcom-munityagencythatbringstogetherbusinessesandsourcesofcapital.Generally,itisstaffedbyvolunteersandisanonprofitagency.SomeLDCsborrowfromtheSBAtorelendthemoneytoaqualifiedsmallbusiness.Insomestates,statefundingisavailable.
Community development corporations (CDCs).UnlikeLDCs,which function largelyonaninformalbasis,CDCsusuallyoperatewithapermanent,full-timestaff.Theyprovideventurecapitalorsecuredfinancingtoeligiblecompanieswillingtorelocatetotheirarea.MostCDCsarenonprofitandreceivefundingfromstateagenciesandprivatesources.
Business development organizations (BDOs).Thesewereconceivedasasortofpackagingcenterwhereabusiness(particularlyinaminorityneighborhood)couldbeputintouchwithlocalbanksorgovernmentofficials.Theyalsohelppreparebusinessplans,financialstatementsandloanapplications.
➤ Observation:Moststateshavesomesortofprogramdesignedtoattractandaidbusinesses,especiallysmallcompanies.Theseprogramsvarygreatlyfromstatetostate,andspaceprecludesdiscussionofthemall.YoucanobtainafreebookletdescribingthevariousstateprogramsbycontactingtheSBAofficenearestyou.
88 / Business Management Daily
Glossary
Accounting equation:Assets=liabilities+stockholders’equity.Accounts payable:Moneythatacompanyowesitsvendorsandsuppliers.Accounts receivable:Moneythatcustomersoweacompany.Accrual accounting:Anaccountingmethodthatrecognizesrevenue/expensetransactionswhentheyoccur,notnecessarilywhencashisreceivedorpaidout.Amortization:Aprocessofwritingoffassetsoverafixedperiod.Assets:Resourcesthatacompanyowns.Audit:Alookatacompany’srecordsandfinancialstatementstoensuretheiraccuracy.
Balance:Thedollaramountofanaccountataspecificpointintime.Balance sheet:Astatementonafirm’sfinancialpositionataparticularpointintime;usestheingredientsoftheaccountingequation:assets,liabilitiesandequity.Bond:Adebtinstrumentsoldtoinvestorsandpromisingtoreturntheprincipalandpayastatedrateofinterestatspecifictimes.Book value:Thehistoricalcostofanasset,lessanyaccumulateddepreciation.Intermsofstock,bookvalueofacommonshareisthecompany’snetworthminusthevalueofpreferredstock,dividedbythenumberofcommonsharesoutstanding.Break-even:Thepointinabusinesswheresalesincomeorrevenueequalsexpenses.Budget:Acompany’swrittenplanoutliningitsspendinggoals.
Capital budget:Ananalysisoflong-termprojectsfortheirriskandprofitability.Capital expenditure:Apurchaseofamajorasset,oraninvestment.Cash:Bills,coinsanddemanddeposits,suchascheckingaccounts.Cash accounting:Anaccountingmethodinwhichatransactionisrecordedwhencashisactuallyreceivedorpaidout.Cash budget:Aplanforcashreceiptsandexpendituresduringagivenperiod.Cash flow:Thedifferencebetweencashreceiptsandcashdisbursements.Alsodefinedasnetincomeplusdepreciation.Collateral:Theassetsacompanyputsuporpledgesassecurityonaloan.Collateral trust bond:Abondinwhichtheissuerusesthestocksandbondsofothercompaniesascollateral.Commercial paper:Unsecuredpromissorynotesgenerallyfloatedby large companies tofillshort-termcashneeds.Common stock:Asecurityissuedbyacompanytoobtaincapital.Holdersofsuchsecuritiesarepartownersandmayormaynotreceivedividends.Convertible securities:Anytypeofbond,note,debentureorpreferredstockthatcanbeconvertedtocommonstock.Cost:Thevalueofsomethingthatwasgivenuptoacquireanitem.
Mastering Business Finance / 89
Cost accounting:Theamassingofinformationforreportingthecostsincurredintheproductionofproductsorservices.Cost of capital:Therateofreturnacompanymustoffertoobtainborrowedorinvestedfunds.Cost of goods sold:Theamountspaidforthepurchasedmaterials,componentsandfinishedproducts;directpayroll;operatingoverhead;andothercostsofacquiringorproducingtheprod-uctsorservicessold.Cost per unit:Theaveragecostofproductionforaparticularvolumeofproduction.Credit (CR):Anaccountingentrythatincreasesaliabilityandrevenue;decreasesanassetandanexpense.Current assets:Allcashheld(primarilyinbankbalancesormoneymarketfunds);resourcesthatwillbeconvertedtocashinthenormalcourseofbusinesswithinonebusinessyear;plusotherresourcesthatcouldorwillbeconvertedwithinayear(marketablesecurities,etc.).Current liabilities:Outstandingtradedebtsandobligations(tradeaccountspayable,short-termnotespayable,currentinstallmentsdueonlong-termdebts,etc.)thatwillfalldueinthecourseofnormalbusinesswithinayear.Current ratio:Totalcurrentassets,dividedbytotalcurrentliabilitiesatthesamepointintime.Indicatestheliquidityofacompany.
Days sales outstanding (DSO):Thisrepresentstheaveragecollectionperiodforaccountsreceiv-able.It’scalculatedasreceivablesmultipliedby365,dividedbyannualcreditsales.Debenture: Anunsecuredbond,orabondforwhichacompanydoesn’tpledgeanyofitsassets.Debit (DR):Anaccountingentrythatincreasesanassetandexpense;decreasesaliabilityandrevenue.Debt/equity ratio:Totalcurrentandlong-termliabilitiesdividedbyaverageshareholders’equity.Deferred income taxes:Thatportionofacompany’scurrenttaxexpensethatwillbepaidatsomeunstatedtimeinthefuture.Depreciation:Theconversionofafixedassettoanexpenseoveraperiodofyears.Althoughchargedagainstincomefortaxcalculationpurposes,itinvolvesnoactualoutlayofcash.Discounted cash flow (DCF):Aprocesstodeterminewhatafuturecashflowisworthtoday.Usedincalculatingnetpresentvalueandinternalrateofreturn.Dividend:Moneyorstockperiodicallypaidtoshareholdersinreturnfortheirinvestmentinacompany.
Earnings per share:Earningsavailabletocommonshareholdersonaper-sharebasis.It’scalculatedasnetincomeminuspreferred-stockdividends,dividedbynumberofcommonsharesoutstanding.Equipment trust certificate:Adebt instrumentofferedto investorstofinancethepurchaseofequipment,suchasrailroadcarsorairplanes.Equity:Theamountofinvestmentthatownersorshareholdershaveinacompany.Alsocallednetworth.(Assets–Liabilities=Equity)Equity turnover:Netsalesdividedbyaverageshareholders’equityfortheperiod.
Factoring:Thesaleofacompany’sreceivablestoathirdparty,calledafactor,“withoutrecourse”(thatis,thefactoracceptsallbad-debtrisks).
90 / Business Management Daily
Finished goods:Productsreadyforsale.Fiscal year:Theannualtimeperiodthatacompanypickstoreportonitsoperation.Thisisgener-allythecalendaryear.Fixed assets:Allproperty,plantsandequipment(buildings,realestate,machines,furniture,etc.)usedinabusiness.Fixed-asset turnover:Netsalesdividedbygrossplantandequipment(beforedepreciationde-duction)fortheperiod.Fixed costs:Thesearecompanycoststhatdon’tchangeassalesactivitymovesupordown.Es-sentially,they’reregardedasoverhead.
Goodwill:Amountpaidinexcessofthemarketvalueofacompany’sspecifictangibleassets.Gross profit:Thedifferencebetweennetsalesorrevenuesandthecostoftheproductsorservicessold.Gross sales/revenues:Theactualtotaldollarsbilledforgoodssoldorservicesprovided,beforereturns,discountsandallowancesgranted.
Historical cost:Theoriginalamountpaidtoacquireanasset.Hurdle rate:Theminimumacceptablerateofreturnonaninvestment.
Income statement:Thesummaryofacompany’srevenuesandexpensesforaparticularaccount-ingperiod,suchasamonth,quarteroryear.Indenture:Anagreementcontainingthetermsandconditionsofabondoffering.Intangible assets:Thoseresourcesofacompanythatdon’thavephysicalform.Internal rate of return (IRR):Amethodthatfindsthespecificpercentageofareturnbydiscount-ingcashflowsuntiltheyreachanetpresentvalueofzero.Inventory:Stocksofgoodsheldforuseinproduction,orforsaleorresalebyacompany.Investment banker:Acompanythatbuysafirm’ssecuritiesandresellsthemtothepublic.Theinvestmentbankerunderwritesabondorstockissue(thatis,absorbsthelossforanypartoftheissueitcannotreselltothepublic).Investment tax credit (ITC):Areductioninacompany’staxliabilityresultingfromtheacquisi-tionofcertainequipment.
Joint venture:Formationofapartnershiporcorporationtocarryoutaparticularproject.Journal:Arecordofacompany’sfinancialtransactionskeptinchronologicalsequence.
Ledger:Arecordofacompany’sfinancialtransactionsastheyaffecteachaccount.Leverage:Ameasureofacompany’sindebtedness.Ahighlyleveragedfirmisonethathasdonealargeamountofborrowingorcontainsagooddealofdebtinproportiontoitsequity.Liabilities:Thefinancialobligationsthatafirmhastooutsidecreditors.Line of credit: Themaximumnumberofdollarsacompanyorabankpermitsacustomerorfirmtooweatanyonetime.
Mastering Business Finance / 91
Liquidity: Ameasureoftheamountofresourcesacompanyhasthatarecashorcanbeconvertedtocashintheneartermtopayitsbillsontime.Loan agreement: Awrittenstatementcontainingthetermsandconditionsofaloan.Long-term debt: Adebtthatisscheduledtomaturemorethanayearfromthepresenttime.
Marginal income: Theamountrealizedaftersubtractingthecostperunitfromthepriceperunit.Market price: Theamountofmoneyashareofstockisworthonastockexchange,theover-the-countermarketortoanindividualbuyer.Marketable securities: Securities,suchasstocksorbonds,thatcanbeeasilysold.Mortgage bond: Abondforwhichtheissuerpledgescertainfixedassets,suchasabuilding,ascollateral.
Net income (profit) after taxes: Thefinal“bottom-line”profitclearedbythebusinessfromallsources.Net operating profit: Grossprofit,lesssellingcostsandadministrativeoverhead.Net present value (NPV): Amethodofevaluatinganinvestmentbyconvertingfuturecashinflowsandoutflowstotheirpresentvaluethroughtheuseofpresentvaluetables.Nonoperating expenses: Interestpaidonlong-termdebts,lossesonsalesofcapitalassets,etc.Nonoperating income: Interestanddividendsreceivedoninvestments,gainsonthedispositionofcapitalassets,etc.
Operating budget:Abudgetthatincludesthesales,expenseandproductionbudgetsofacompany.Itprovidesalltheinformationnecessarytoproduceaproforma(projected)incomestatement.Operating margin: Thepercentagederivedwhenoperatingincomeisdividedbysales,givingyouaprofitabilityratio.Outstanding shares: Sharesissuedbyacompanyandownedbyshareholders.
Par value: Thenominalorfacevalueofstocksandbondsatthetimeofissuance.Partnership: Anunincorporatedbusinessownedbytwoormorepersonswhoarepersonallyresponsibleforallthebusiness’debts.Payback: Amethodthatestimatesthetimeitwilltaketoreceiveenoughcashfromaprojecttorecoverthecashinvestedinthatproject.Preferred stock: Ashareinacompanythatusuallycarriesafixeddividendandentitlesitsownertopaymentpriortothatofacommonshareholderintheeventofbankruptcy.Private placement: Thesaleofacompany’ssecurities toan institutional investororgroupofinstitutionalinvestors,ratherthanofferingthemtothepublic.Pro forma statement: Aprojectedorbudgetedfinancialstatement.Profit-and-loss (P&L) statement: See Income statement.Alsocalledearningsreport.Profit margin: Thepercentagederivedwhennetincomeisdividedbynetsales.Alsocalledreturnonsales(ROS).Proprietorship: Theunincorporatedbusinessofasingleowner.
92 / Business Management Daily
Raw materials: Purchasedcomponentsthatgointomakingaproduct.Receivables turnover: Creditsalesdividedbyaverageaccountsreceivableforaperiod.Retained earnings: Theprofitsafirmearnedduringitsexistencethathavenotbeendistributedtothestockholdersasdividends,butkeptinthefirm.Return on assets (ROA): Netoperatingprofitfortheperioddividedbyaveragetotaltangibleassetsfortheperiod.Return on equity (ROE): Netprofitfortheperiod,dividedbyaverageshareholders’equityfortheperiod.Return on investment (ROI): Ageneraltermtodescribeagroupofratios(ROA,ROE,ROS)thatmeasureacompany’sprofitability.Return on sales (ROS): See Profit margin.
Shareholders’ (stockholders’) equity: Theparvalueofthecorporation’scommonandpreferredstock,plusanypaid-inoraccumulatedcapitalsurplusovertheparvalue,plusanyearnedsurplusorearningsretainedforuseinbusiness.(Equity=Assets–Liabilities)Sinking fund: Moneysetasidebyacompanytorepurchasepartofabondissue.Small business investment companies (SBICs): Specializedventurecapitalfirmslicensedandpartlyfinancedbythefederalgovernmenttofillafinancinggapforsmallfirms.Statement of cash flows: Thepresentationofacompany’scashreceiptsandpaymentsoveraperiodoftime.
Tangible assets: Thoseresourcesofacompanythathavephysicalform,suchasabuildingorplant.Treasury stock: Sharesacompanyownsthroughtherepurchaseofthestockfromshareholders.Trial balance: Acomparisonofthetotalsofdebitcolumnsforallaccountswiththecreditcolumnsforallaccounts.Theyshouldbalance.
Variable costs: Coststhatdirectlydependonsalesactivity.Variance: Thedifferencebetweenexpectedorbudgetedresultsandactualresults.Venture capital: Fundsthatapersonorcompanywillingtotakeariskinvestsinasmallbusiness.
Work-in-process: Goodsonwhichproductionhasbegun,butwhichhavenotyetbeenfinished.Working capital: Currentassetslesscurrentliabilities.
Zero-base budgeting (ZBB): Abudgetingprocessinwhichdepartmentheadsormanagersmustjustifyallexpenseplansandrankthembasedontheiroverallcontributiontothecompany.