Surviving a Debt Euroclydon (Segment V)

Preface: Numerous business owners have an intuitive feeling on working capital levels, but quantifiably grading working capital provides an understandable and mathematical measurement where your business is at now, and where your business working capital could and should be.

Surviving a Debt Euroclydon (Segment V)

Credit: Donald J. Sauder, CPA |CVA

Measuring working capital is the second easy tool to help maintain a well-oiled enterprise. Working capital is a balance sheet calculation, or current assets minus current liabilities equals your business working capital. Working capital measures the operational liquidity level of a business.

So what are currents assets? They are often your cash and equivalents accounts, accounts receivable, vendor prepayments, and inventory. Assets that are easily convertible into cash with a year. Current liabilities are often your accounts payable, credit cards, line of credit, tax liabilities, accrued expenses, customer prepayments, and deposits, and don’t forget the current portions of debt.

To precisely measure an enterprise’s working capital, it is necessary to have accurate accounting with appropriate accountant oversight for proper classifications of both current and noncurrent assets and liabilities.

The current ratio applies for the same financial numbers as working capital, yet instead of subtracting current liabilities from current assets, the current ratio divides current assets by current liabilities. Typically, a current ratio should be higher than two and likely two and a half, to be solidly established from an analytical measurement metric.

….the working capital grading tool is to help clients measure optimal working capital levels, i.e., how much is enough when discussing working capital? Let’s call it the working capital grade. It requires analysis of both the balance sheet and profit and loss statement.

Working capital measurement is an analytical approach to monitor a business’ capacity to continue operations with sufficient cash flows and to pay operating expenses and satisfy current liabilities cash uses.

Sauder and Stoltzfus, as an entrepreneurs CPA firm, has developed a working capital grading tool to help clients measure optimal working capital levels, i.e., how much is enough when discussing working capital? Let’s call it the working capital grade. It requires analysis of both the balance sheet and profit and loss statement.

Tracking the working capital balance from consecutive period to period will provide a data map, but you need to know, “Do you have enough yet?”

Working capital seems easy enough to calculate. You look at your financial statements and subtract current liabilities from current assets. If you should have the financial accuracy to calculate the balance, the numbers independently, do not provide much analytical guidance. Tracking the balance from consecutive period to period will provide a data map, but you need to know, “Do you have enough yet?”

Numerous business owners have an intuitive feeling on working capital levels, but quantifiably grading working capital provides understandable and mathematical measurement where your business is at now, and where your business working capital could and should be.

Here’s how we grade working capital. You can do math or follow along with current assets minus current liabilities as the formula.) Let’s say the cash $5,000 + accounts receivables $45,000+ inventory $70,000 is $120,000. Now subtracting accounts payable $30,000 + accrued wages $15,000 + current portion of debt $25,000 is $70,000. Now the working capital calculation is $120,000 – $70,000 = $50,000.

In our example, the working capital was $50,000, so the business is not yet solidly positioned or fully prepared for a debt Euroclydon.

Next, we compare that working capital level of the balance sheet to the profit and loss statement, measuring both direct labor expenses, and operational or general and administrative costs on a quarterly basis, e.g., what do you pay indirect labor expense or general and administrative expense, on average, every three months? This example can include multiplying a year of data with .25 for 1/4th of the annual costs or merely looking at quarterly data. This number is an estimate only, like a professor grading essay papers, the difference between the grade of a B+ or A is discretionary.

Now following with a business that has a direct labor expense in cost of sales of $300,000 per year, you would multiply the twelve-month fiscal year number by 0.25; that calculates to $75,000 per quarterly 300,000 * 0.25). If your operating expenses or general and administrative expenses are $250,000 for the twelve-month fiscal year, then you would multiply that balance by 0.25 to arrive at a calculated $62,5000 ($250,000* 0.25).

The greater of those two numbers is your optimized working capital. That is the $75,000 or $62,500. The greater is the direct labor of $75,000. Do you make the grade? Your business is solidly pillared if you have the greater of these two numbers in the working capital formula, i.e., $75,000.

In our example, the working capital was $50,000, so the business is not yet solidly positioned or fully prepared for a debt Euroclydon. If you have working capital above the calculation, your business can take on additional risk to safely develop the expansion of operational activity, as long as you continue to maintain or monitor appropriate working capital levels in your business.

In the above-calculated working capital scenario, the $50,000 of working capital measurement divided by $75,000 is a 66% ($50,000 balance sheet working capital / $75,000 profit and loss measurement)  Making the grade? Yes, it’s that simple.

The working capital grading tool works like this:
1.    35% equals one month of working capital
2.    70% equals two months of working capital
3.    100% equals three months of working capital.
4.    You can score well above 100% in a firmly positioned business, and you’re ready for the debt Euroclydon.

If your business working capital grade is below 15% to 25%, your business likely needs immediate help from an expert financial advisor. On the other hand, the $25,000 increase required from $50,000 to achieve $75,000 can be obtained with steady additional earnings and profits retained in the business, i.e., you can earn your way out of the problem, or maybe a long-term amortization of say a line of credit, i.e., reducing current liabilities.

To be continued.

Did I Purchase What You Sold?

Preface: Buyers are well-advised to give appropriate attention to asset allocations for tax purposes with transactions to avoid being pressured by uncooperative sellers after signing.

Did I Purchase What You Sold?

By Jacob M. Dietz, CPA

Sometimes a hardworking entrepreneur decides to move on to new adventures. The new adventure could be another enterprise, it could be mission work, or it could be a slower lifestyle and grandchildren. When this happens, there may be a sale of the business. When selling a business, make the allocation of the price a part of the agreement of the sale.

The Case of the Missing Allocation

Imagine if a custom chopping business owner named Reuben decided to sell his business, ABC Custom Chopping, LLC to another custom operator, Henry. He is selling the entire business including the equipment, the customer list, the employees, etc.

They agree to sell it for $750,000. In June, Henry writes a check (with the help of a bank loan) and takes over the business. Everything seems great until February.

In February, Reuben goes to his accountant and says he sold the business for $750,000. His accountant asks for an allocation schedule showing how much was paid for different asset categories. Unfortunately, no such allocation was ever created.

Purchase Price Allocation to Assets

What is an asset allocation, and why does it matter? IRS Form 8594, Asset Acquisition Statement, lists 7 classes of assets. A full treatment of this form is beyond the scope of this blog, but in certain cases when a business sells both the buyer and seller must fill out form 8594, which shows how the price of the business is allocated among asset classes.

Ignoring most of the classes, let’s look at class V and class VII. Class V includes various items, including equipment. Class VII includes goodwill. Goodwill has also been referred to as “blue sky” and can be the amount of the purchase price not allocated to other items.

Back to Reuben and Henry. How should they allocate the purchase price? Henry hopes to allocate as much as possible to the equipment, which is class V. Why? Equipment can be depreciated quicker than goodwill is amortized, and with accelerated depreciation Henry may even be able to deduct it all in year 1. Goodwill (class VII) on the other hand, is amortized (expensed) over 15 years.

Reuben, however, may want to allocate more to goodwill. Why? All or part of the sales price allocated to equipment will be subject to ordinary income treatment. The price allocated to goodwill can be subject to capital gain treatment. Ordinary income is often taxed at a higher rate than capital gain income.

Unfortunately, Reuben and Henry are motivated in opposite ways on how to allocate the purchase price, and they lack a business incentive to compromise. Henry has the business. Reuben has the money.

Agree when Negotiating

What could have been done differently? They could have agreed on an allocation before the deal was signed. When they were still negotiating the price, then they would have had a business incentive to compromise.

For example, assume Henry wants to allocate $700,000 of the purchase price to equipment, and Reuben wants to allocate $600,000 to equipment. They could perhaps meet in the middle, and agree to $650,000.   Alternatively, perhaps Reuben could agree to Henry’s number, $700,000 for the equipment, but negotiate an additional $10,000 or so to the sales price.

Although it may seem like one extra hurdle to selling the business, make sure your purchase agreement includes an asset allocation. What is purchased should be the same as what is sold. If there is disagreement, it is better to compromise at the time of the sale instead of trying to agree months later when the business incentive to compromise is no longer present. Months after the sale is a good time to enjoy the new adventure, but it is not a good time to argue over the allocation.

Surviving a Debt Euroclydon (Segment IV)

Preface:  A fisherman is certainly not ready to troll for big-game saltwater fish with a 20lb braided test line. But if you’ve got an 80lb braided test line, then you should be equipped to troll the saltwater seas for Marlins.

Surviving a Debt Euroclydon (Segment IV)

Managing a business with a high liability to assets ratio requires continuous cash flows to keep the financial pumps primed. Preparing appropriately for such changes in cash flows, for even short durations i.e., rain on a parade, can ease cash flows shock risks and strengthen balance sheets.

Preparing for a Debt Euroclydon can begin with two easy tools. Tool one is working on optimizing the analytical ratio of equity to total assets or total liabilities and equity. To calculate this ratio accurately requires precise balance sheet accounting and accurate month-end closing processes.

A business that has accurate financials with an equity to total assets ratio above 80% is prepared for a host of financial risks. To build a balance sheet of that strength requires either back-to-back years of grand performance earnings that need to be retained in the enterprise, or a strong capital base. A business with less than 50% equity to total assets is average in balance sheet strength, and with when measured with 20% or less equity to total assets is operating with maximum risk. The analytical ratio tool of equity to total assets can be likened to fishing with a braided fishing line. A fisherman is certainly not ready to troll for big-game saltwater fish with a 20lb line. They are advised to best fish easy for small native fish because the line will snap on the first big-game bite. But if you’ve got an 80lb test line, then you should be equipped to troll for some saltwater Marlins.

Here is how you can assess your businesses strength with the Equity to Total Assets or Total Liabilities + Equity ratio analytic.

Analytical Ratio

Notice on the left side of the above analytic with the $5,000 of equity, there is a 3% equity ratio to total assets on a hypothetical $150,000 of total assets. Building equity can occur with two possibilities. 1) earn more net income and retain it in the business, 2) contribute capital to the company in the form of investments. The 87% ratio on the right side of the above analytic is the equivalent of 80lb braided fishing line you’re ready to plan to fish for Marlins. In addition to building equity, a keen financial analyst would also suggest to scale back the balance sheet reducing both assets and liabilities with say a sale of assets including lower inventory, or collections on receivables with a corresponding payment of balance sheet liabilities with the cash.

Watching trends in this ratio will provide confidence in your financial management decisions. The ratio is rarely static and should be closely monitored for the range on trend developments. A 100% is unrealistic because there are usually some accounts payable, accrued expenses, and say credit card expenses month-to-month.

If you measure this ratio analytic on your business and it is below 20%, don’t expect to win the current weeks saltwater fishing derby for the big game. Begin to accumulate and build the ratio on smaller fry until you have the capital to troll for larger big-game saltwater fish in the future, i.e., additional employees and general overhead.

To be continued…..

Surviving a Debt Euroclydon (Segment III)

Preface: You’re living the college student dream if you’re debt free.

Surviving a Debt Euroclydon  (Segment III)

Then the hypothetical debt Euroclydon came. The only man who sticks closer to you in adversity than a friend is a creditor – Author Unknown. Today, debt drives the economy from credit cards and real estate mortgages to personal and business lines of credit.

We can gain valuable and keystone business insights into the economic power of debt and the credit cycles from the book, The Big Debt Crisis; credit: author Ray Dalio.

If you understand the game of Monopoly®, you can pretty well understand how credit cycles work on the level of a whole economy…..Early in the game, “property is king” and later in the game, “cash is king.”

Now, let’s imagine how this Monopoly® game would work if we allowed the bank to make loans and take deposits. Players would be able to borrow money to buy property, and, rather than holding their cash idly, they would deposit it at the bank to earn interest, which in turn would provide the bank with more money to lend. Let’s also imagine that players in this game could buy and sell properties from each other on credit.

If Monopoly® were played this way, it would provide an almost perfect model for the way our economy operates. The amount of debt-financed spending on hotels would quickly grow to multiples of the amount of money in existence. Down the road, the debtors who hold those hotels will become short on the cash they need to pay their rents and service their debt. The bank will also get into trouble as their depositors’ rising need for cash will cause them to withdraw it, even as more and more debtors are falling behind on their payments. If nothing is done to intervene, both banks and debtors will go broke, and the economy will contract. Over time, as these cycles of expansion and contraction occur repeatedly, the conditions are created for a big, long-term debt crisis.

Today, central banker vocabulary doesn’t include the word “bankruptcy.” As of May 2019, the United States consumers in aggregate had $4.02 Trillion in consumer debt, says credit cards, and $1.50 trillion of student debt on educational loans, and $1.20 trillion of auto loans. In 2018, the average American household had too much debt, with an average of $135,000. The average US household had $47,500 of student loans, $27,500 of auto loans, $6,000 of credit card debt, and the remainder of the $135,000 of total debt is either a mortgage, line of credit, and home equity loans. With average wage earnings of $60,000 per household, approximately 8% to 10% of Americans think they will never be free of credit card debt in their life. The statistics are increasingly bleak for long-term economic vibrancy with the absence of continual injections of credit for new consumer spending highs.

Now, let’s ask a rhetorical question. Where will this average American likely receive the necessary future capital to acquire or pay for what your business will sell? Will it be from new credit cards, or say will it be a mortgage? Will it be a home equity line of credit? You hope it’s discretionary earning, right? Look at the statistics. Simply because someone earns more than $60,000 doesn’t say they save more capital or have a higher percentage of investable assets than someone who is earning less. Higher earnings permit more opportunity to accumulate debt with greater credit access. The economic gaps among the haves and have nots continue to widen creating expansions in the underlying tectonic pressures in the greater society.

A debt crisis is deflationary because the artificial price increases per the Monopoly game example above, simply cease to support inflated asset prices when the credit compressor stops. Deflation is a decline in asset prices. Hence real estate and business values decline in deflation. A Debt Euroclydon in terms of this article does not outline what happens in that scenario. The best answer may be that the actual economic playbook is almost impossible to design for most, but likely outlines bleak economic conditions that have not been seen in most generations in the business industry and entrepreneurship today.