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I help businesses in financial trouble.
Most of my newsletters talk about what to do in these situations. Today’s newsletter takes the opposite perspective: key financial things you must do to stay prosperous and, as a result, never become one of my clients.
The list is short and simple.
Executing the things on it, not so much. Here they are:
- Know where your business has been financially and where it is headed.
- Make good resource allocation decisions.
- Earn more than the business’s cost of capital.
- Don’t screw up your capital structure.
- Have the right tax structure.
- Transfer risk appropriately and understand the substantial risk the business retains.
Know Where Your Business Has Been Financially and Where it is Headed
Where your business has been:
This requires an accurate, accrual-based income statement and balance sheet ready and
reviewed
by management no later than two weeks after month end. They should be presented in GAAP format once a year for outside parties and, unless the business is very small, the statements should be reviewed and ideally audited by a reputable accounting firm (reputable is in the eyes of the readers). To produce accurate and timely financial statements the business must have the proper systems, internal controls, and knowledgeable staff.
Where your business is headed:
Financial projections are needed, for which there are two requirements. The first is accurate financial statements that represent the past. Second, and often overlooked, is being able to translate the business model into a financial model. The simplest way to do this is to start with a sales projection and then project all expenses as a percent of sales. The problem with that approach is some expenses are variable and some are fixed. Often there is some measure of volume. Project that, then project sales and variable costs based on volume. (More here.)
But how often and how far out should your projections run?
That depends on how fast your business conditions can change and the purpose of the projection. When I was in the pulp and paper business, where underlying commodity prices change frequently and drastically, we projected 30 and 60 days out
twice
each month. When I was in the rental car business, we projected out 12 months or so just three times a year based on seasonality and fleet purchasing decisions. In addition, a multiyear projection should be made annually.
It is important to project the balance sheet and then cash flow when doing projections longer than the next three months. Any loan covenants should be projected as well. This projection can foresee the need to increase borrowing, defaults on credit lines, and the ability to make distributions or dividends to owners.
Make Good Resource Allocation Decisions
Supporting the enterprise in making good resource allocation decisions is the strongest finance lever to increase its value. Resources are always scarce, so it is important to understand their alternative uses. The second-best use of those resources in question is the
opportunity cost
of choosing the best alternative.
The two critical steps here are identifying the constrained resource and getting the time frame right.
Why time frame? For longer time frames, the constrained resource can be increased — of course, at the cost of some other constrained resource. Here, finance needs to understand what the common resource constraints are and have a measure of opportunity cost.
During the pandemic, a manufacturing client of mine did not have the staff to produce all the orders in a reasonable time. In this case,
the critical constraint was people.
So, I helped my client understand the profitability of its products and customers by man hour of its key manufacturing lines. That meant taking into account the incremental profitability of each item and customer per unit sold
and
how fast the machine ran based on that particular product run (some products ran much faster than others). My client’s recently installed ERP system will soon have these numbers readily available.
Earn More Than the Business’s Cost of Capital
Simply put,
the cost of capital is
the minimum return that investors expect for providing capital to the company.
If a business invests in a project that returns less than its cost of capital, the value of the business is reduced (and vice versa). If the business continues to earn less than its cost of capital, eventually it will lack the funds to invest and stay competitive.
Capital is the most critical constrained resource, so
the cost of capital is really the opportunity cost of investing in projects within the business.
Accounting records don’t provide this cost as the cost of capital is market-based and includes the
cost of equity
which is not represented at all in financial statements. The concept is not complex, but calculating the cost often requires access to proprietary databases, particularly for private companies. This is why most businesses get outside help on this.
Don’t Screw Up Your Capital Structure
In
theory, capital structure doesn’t matter. It has been shown both theoretically and empirically that the more debt relative to equity a company has, the more expensive equity becomes relative to debt. So the average cost of debt and equity is a wash.
Reality is different — this is an optimization opportunity.
First, because interest is a tax-deductible expense and dividend payments or distributions to equity are not. Also, debt service load, often measured by the
Fixed Charge Coverage Ratio
will vary depending on the debt structure. The debt service payments on an interest-only credit line have less of a load than an amortizing term loan for the same amount. There is also the issue of covenants and guarantees.
Just about all companies, even large ones with treasury departments, get at least some outside help for this one.
Have the Right Tax Structure
Taxes suck money out of a company.
Pay more than your competitor and they will have more funds to reinvest in their business and be better positioned to compete with you. And, of course, no business wants to leave money on the table for the IRS or any other taxing authority.
In the United States, the basic choices are to be a
C-Corp
, where taxes are paid by the business and dividends are taxed by the recipient; an
S-Corp
, where taxes are paid by the shareholder but there are some restrictions on stock type, etc.; or taxed as a
partnership or individual owner
where there are no such restrictions but there can be other catches and taxes are also paid by the owner.
Many smaller businesses opt for the S-Corp or some other pass-through structure thinking they will pay lower taxes. But, if the plan is to reinvest the money in the business, there are often fewer after-tax funds to do so because the highest marginal tax rate for individuals is higher than the tax rate for C-Corps. Then there is the issue of what happens tax-wise if the business is sold. For individuals, there are estate taxes to consider as well.
It sounds complicated because it
is
complicated.
The tax code in the United States is a function of political compromise, not logical or economic thinking. How weird can it get? Back in the mid-90s, when I worked for State Street Bank, the video store lobby (remember them?) got a special tax break if the video store was set up as a REIT, a type of pass-through tax entity. A good chunk of the Bank’s investment portfolio was owned by an entity called High Street Video Rental. Go figure — the bank’s tax experts sure did.
Don’t forget state and local taxes (SALT). If you operate in foreign countries, there is lots more too.
Transfer Risk Appropriately and Understand the Substantial Risk the Business Retains
Simply put, have the right insurance coverage and understand it.
Typically, insurance is for low probability but catastrophic perils such as fire, earthquake, flood, hurricane, etc. High probability risks are retained by the business, so make sure to understand those retained risks.
Sometimes, various laws require insurance for risks that would normally be retained, at least up to a significant dollar amount. The classic examples are worker’s compensation insurance for manufacturers and vehicle insurance for businesses with large fleets of trucks and cars. Here, there are ways to self-manage or outsource claim management but retain a significant amount of risk, all under the umbrella of insurance.
A Few Pointers...
Invest in good people, systems, and internal controls.
My own experience is that an ERP system, where all the data (including accounting data) is in one big database, is easier to use and will be used more frequently than trying to tie together different data sources for analysis and reporting purposes. If lots of the same analysis is done repeatedly in Excel, consider investing in a reporting and analysis software package.
Get outside help when needed.
The obvious areas are legal, tax, insurance, and the cost of capital. Smaller companies should consider fractional help such as a part-time CFO or bookkeeping.
Know the limitations of your in-house support and outside advisors.
A controller VP/finance may be good for the day-to-day but struggle with the right capital structure, projections, and so forth because they don’t do those often. Same for outside advisors. Tax preparation and estimates is different than tax planning. As a company’s size and complexity increase, its needs for in-house staff and outside advisors change.
Tie everybody together.
Don’t keep people in the dark about decisions the business is considering. For outsourced and fractional help, make sure to put time on the calendar to talk about the business and where it is headed.
Get finance right and your business will prosper, stay out of trouble, and remain off my client list.
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