A primary objective of most business owners is to build wealth by increasing the company’s value over time. This is accomplished when “free cash flow returns” are maximized on invested capital. Ideally, the owner would also prefer to achieve this result with the least amount of risk possible.
This shareholder value creation process is typically accomplished through many incremental decisions and steps taken over a long period of time. Therefore, the business owner must be able to recognize the individual factors and inter-relationships involved.
Many decisions that business owners make often involve trade offs. Therefore, the cause and effect of every financial decision must be understood in the context of the value creation equation.
Consider this example:
An inventory dependent business that lacks real-time reporting associated with a perpetual system may, in the short term, save money on accounting technology, conversion, training and labor costs. However, in the long term, those savings will likely pale in comparison to the benefits of a computerized perpetual inventory system.
This is because in the absence of a computerized inventory system, costs related to inefficiency and lack of controls result. These costs will likely manifest in:
(1) non-optimal pricing on purchases.
(2) failure to track and use purchase discounts.
(3) overstocking obsolescence.
(4) employee theft in the absence of inventory records.
(5) higher storage and insuring costs of excess inventories.
All of these costs ultimately expend cash and decrease profitability and equity. It is just that the expenditures related to poor inventory management are less obvious simply because they get lost in purchases expense.
Of course, deriving the benefits of a perpetual inventory system is not without it own costs. There is no question that maintaining a perpetual system is more labor and skill intensive. Every aspect from purchase to sale of the items must be carefully entered in the system in order to properly track the movement of the goods up to the point of sale.
Consequently, given that most decisions like this involve trade offs, it is important to recognize, understand and quantify the real cost of each alternative. Will the action to be taken ultimately translate into building value or wasting it?
How exactly to make these choices is not always clear. However, there are basic “drivers” that impact profitability and, hence, shareholder value over the long term. Understanding the positive (or negative) influence of these drivers is important in making correct business decisions. Basically, they fall under three broad categories: operating, investment and financing related.
Operating Drivers are those which directly influence profitability of the company. They are associated with any action that results in a direct increase in revenues or reduction in expenses. Therefore, the income statement, rather than the balance sheet, is the primary focus. These include:
Sales price Should be set at an optimal level to generate the highest revenue without loss of customers to competitors. Can additional value be added to the product that justifies a greater marginal sales price over the additional marginal cost of materials and labor required?
Product or service mix This involves having the right combination of goods or services whereby unprofitable products can be identified. Without an accurate accounting system where revenue and cost detail can be tracked, it won’t be possible to identify “true” profitability of a specific product or service. Accurate data may reveal that a specific product or service thought to be profitable, actually is not. Labor and other resources might better be committed to other products or services.
Sales Volume A sufficient quantity of a product or service must be sold to achieve profitability. If sales volume can be increased without increasing related fixed costs, then the gross profit from the additional sales will contribute directly to bottom line profit. Does sufficient capacity in the market exist in which to grow your product market share?
Productivity This relates to achieving the most cost effective means to produce a product or service. Any expense squeezed from the process makes a positive profit contribution.
Income taxes Affect most transactions. Generally, decisions should be based on the marginal “after tax” contribution to profitability and wealth creation of the company.
Investment Drivers involve the optimal management of capital employed in the business. Here, the focus is on balance sheet assets. Investment drivers include:
Minimizing idle cash balances Keep excess funds in interest bearing accounts or consider paying down debt since the interest savings most certainly will be greater than the interest earned on the idle funds. However, do not pay down excessive debt amounts if it is likely to lead to a cash shortage later.
Accounts receivable management Accelerating collections lessens the cost to finance those receivables. Also, any policy changes that result in tighter credit restrictions without losing sales will have a positive impact on profitability and cash flow as a result of fewer bad debts.
Inventory management Minimize capital in inventory. This involves avoiding excessive quantities, monitoring obsolescence, better purchasing procedures, using “economic order quantities”, adopting “just in time” ordering or any other technique which minimizes the length of time for capital to be turned over in the purchases to sales cycle.
Capital purchases Can be justified based on various capital asset analysis models such as “net present value” or “internal rate of return” (beyond the scope of this article but will be covered as a future topic). Again, income tax considerations are important in plant and equipment decisions to maximize the tax savings generated by the depreciation write-offs. Another factor to consider with capital assets is whether to lease or purchase the asset.
Financing Drivers are associated with the liabilities and equity components on the balance sheet. Whether financing comes from lenders or owners, the objective is to obtain the least amount at the lowest cost of capital rate. (A future topic discussing cash flow budgets will address this in greater detail) Financing drivers include:
Accounts payable management This involves having an appropriate system in place that allows invoice due dates monitoring and making sure there is liquidity to take vendor discounts.
Optimizing debt versus equity mix Although borrowed capital allows a business to leverage its earnings during periods of growth, the interest costs also magnifies the losses during lean periods.
The optimal mix of debt versus equity financing will vary depending on the business and the industry. Financial formulas and statistical models can be used to calculate business profitability at various mix levels. By using these methods, the optimal mix of debt versus equity can be determined. Generally, this will fall somewhere between 40 to 60% debt as a percentage of overall capital for many businesses.
Cost of capital The obvious goal is to finance a business with the least expensive source of capital at the most favorable repayment terms. The importance of establishing a good relationship with your lender cannot be over emphasized.
Any action the company can take to reduce the company’s perceived risk and improve the structure of its balance sheet will tend to have a positive influence on lowering the cost of capital