Business Strategies

Capital budgeting is a quantitative decision-making approach for evaluating and choosing between one or more investment projects under consideration by an organization. Through the use of the capital budgeting structured approach, the organization attempts to identify the profitability and risk complexion of an investment alternative.

Essentially, the capital budgeting approach is all about making well informed investment decisions. The quantitative process entails assessing the profitability and risk complexion of an investment decision under consideration. The contemplated profitability resulting from an investment decision based on the systematic capital budgeting approach serves as the justification for making the decision in the first place. Rather than simply winging it when selecting and embarking on a capital expenditure, the capital budgeting approach provides the support upon which responsible managers rely.

As noted in this informational video, the capital budgeting decision-making process is typically applied to investment projects concerning capital assets such as real estate (buildings, land), heavy equipment, machinery, and vehicles. The unique challenges encountered when budgeting for capital assets can be summarized as follows:

• The eventual outcome is uncertain.

• Large amounts of money are involved.

• The investment decision represents a long-term commitment.

• The investment decision may be difficult or impossible to reverse.

The capital budgeting process involves calculating one or more of what are called “capital budgeting metrics” and evaluating those metrics alongside the organization’s corresponding financial goals.

Examples of suitable capital budgeting metrics frequently used in industry are as follows (as noted in this Wikipedia list):

• Accounting rate of return
• Average accounting return
• Payback period
• Net present value
• Profitability index
• Internal rate of return
• Modified internal rate of return
• Equivalent annual cost
• Real options valuation

An effective capital budgeting project shouldn’t necessarily be limited to evaluating just one of these foregoing metrics. Rather, each of these metrics tends to bring something unique to the table. Management should be encouraged to use more than one of these metrics in unison when evaluating an investment project in order to obtain a more well-rounded, comprehensive picture of how the project’s contributions will achieve the organization’s financial goals.

The most frequently used metrics from this list are the following:

• Payback period: evaluates how long it takes to recoup the investment project’s initial investment. When dealing with mutually exclusive projects, the project with the shorter payback period should be selected.

  The advantage? It’s relatively simple to calculate.

  The disadvantage? It doesn’t take into account the time value of money.

• Net present value: Evaluates the present value of future cash inflows net of future cash outflows. The general rule of the NPV method is that independent projects are accepted when NPV is positive and rejected when NPV is negative. In the case of mutually exclusive projects, the project with the highest NPV should be accepted.

  The advantage? It takes into account the time value of money.

  The disadvantage? It’s more complex to calculate. The evaluation of the investment project could potentially be penalized if an unreasonable discount rate is used. Furthermore, future cash flows are not guaranteed.

• Internal Rate of Return (“IRR”): The IRR is the interest rate that when applied to the future net cash flows will yield a net present value equal to 0.

  A capital project must produce an IRR that is higher than the company's cost of capital. Once this hurdle is surpassed, the project with the highest IRR would be the wiser investment, all other things being equal (including risk).

  The advantage? It is relatively easy to arrive at. It introduces a time value of money influence to the investment analysis.

  The disadvantage? The IRR is an internal metric in the sense that it ignores the impact of external environmental factors such as inflation.

While not a perfect tool, the capital budgeting process introduces a systematic and rational tool for either deciding to move forward with a particular investment project or deciding to forego the investment project. A suggested approach to mitigating the imperfection of the process is to calculate and evaluate multiple metrics rather than confining the view to only one metric.

Financial Ratios

Financial ratios are metrics that help measure the health and performance of a business. Such ratios help tell the story behind what’s disclosed in the company’s financial statements, and they are relevant for both small and large businesses. They are also referred to as Key Performance Indicators (KPIs).

Financial ratios are calculated based on information contained within the company’s financial statements. Once calculated, a particular ratio is put to use by making the following comparisons:

Besides helping you evaluate the health of a company, financial ratios can identify, through the use of trend analysis, potential problems in the realms of profitability, liquidity, return on equity, going concern, potential bankruptcy, solvency, etc.

On the other hand, the use of ratios can help identify “winning combinations” that the business owner never even considered.

Main Categories of Financial Ratios

1. Liquidity Measurement Ratios

2. Profitability Indicator Ratios

3. Debt Ratios

4. Operating Performance Ratios

5. Cash Flow Indicator Ratios

6. Investment Valuation Ratios

Source: Investopedia

Additional Financial Ratios (KPI’s) Widely Used By Small Businesses

• Cash Conversion Cycle 

• Return on Investment 

• Gross Profit Margin 

• Net Profit 

• Net Profit Margin 

• Debt-to-Equity Ratio 

• Operating Expense Ratio 

• Price Earnings Ratio

• Operating Profit Margin 

• Working Capital Ratio 

• Return on Assets 

• Return on Capital Employed 

• Return on Equity 

• EBITDA 

• Total Shareholder Return

Source. Tax Prep for Artists

Financial Ratio Example – Current Ratio

Current Ratio = Current Assets / Current Liabilities

The Current Ratio is a widely used metric for evaluating short-term liquidity. It provides a “snapshot” of the company’s ability to pay its bills that are coming due in the short-term. If the metric is a positive value equal to or greater than 1, then it would appear the company can pay its bills.

On the other hand, if the metric is a negative value equal to or less than 1, then the company may encounter difficulty in paying its bills and could conceivably go bankrupt.

Financial Ratio Example – Cash Ratio

Cash Ratio = Cash + Cash Equivalents / Current Liabilities

Somewhat similar to the Current Ratio is the Cash Ratio. The only difference between the two ratios is that the Cash Ratio omits from the numerator all components of current assets other than cash and cash equivalents. “Cash” is immediately available for paying. “Cash Equivalents” are assets that can more easily be converted into cash in the short-term, and are more liquid than other non-cash assets.

As in the case with the Current Ratio, if the metric is a positive value greater than or equal to 1 then the company should be able to pay its bills. On the other hand, if the metric is a negative value less than or equal to 1 then the company may be in trouble.

Financial Ratio Example – Debt Ratio

Debt Ratio = Total Liabilities / Total Assets

The Debt Ratio is an indicator of a company’s overall solvency. If the debt ratio is greater than 1, the company has more debts than it’s able to pay off and its ability to continue as a going concern is brought into question. On the other hand, if the ratio is a value less than 1, then it’s assumed the company is solvent and able to pay off all of its debts from the assets it has on hand.

Financial Ratio Example – Gross Profit Ratio

Gross Profit Ratio = Gross Profit / Net Sales

This ratio is customarily used to evaluate profitability. It looks at how much profit resides in each dollar’s worth of net sales. In other words, how profitable are the company’s net sales dollars? As the gross profit ratio gets lower, the amount of profit realized from each dollar’s worth of net sales also lowers. The closer the gross profit ratio is to 1, the more profitable net sales are assumed to be.

Therefore, “Net Sales” are by definition gross sales dollars less items such as discounts, returns, and refunds. Gross Profit is calculated by subtracting cost of sales from total revenue.

KPI’s Other Than Financial Ratios

So far, the discussion has centered on financial ratios that comprise what the world has come to know as Key Performance Indicators (“KPIs”). However, there are indeed some very relevant “non-financial ratio” metrics that can shed some light on factors and issues affecting the performance of the company. It is a mistake to ignore and underestimate the existence and importance of these metrics.

Employee Turnover

Let’s first look at “employee turnover,” or employee satisfaction, as an example of a KPI that is not a financial ratio. A significant part of the success of a company is dependent on a stable work force. The facts already show that an unstable work force has a negative impact on performance because there is a cost associated with hiring and retaining qualified personnel.

If the work place has a high rate of turnover then something is definitely wrong and needs to be looked into -- be it widespread dissatisfaction with management, compensation, benefits, etc. High turnover also needs to be addressed because the business plan likely assumes that matters such as high turnover are a “non-issue.”

Customer Service

Customer service is another relevant KPI that is crucial to a company’s success story. There is no company and there is no business to be had unless the company has customers who are satisfied and keep coming back. The business plan likely assumes that there is not even a little problem with customer dissatisfaction. There is no easy off-the-shelf formula to begin evaluating and fixing a problem with customer dissatisfaction.

Management Needs to Systematically Review Non-Financial Ratio Factors

The point is that management needs to develop a system of its own KPI metrics and maintain a systematic program of review that gives attention to the non-financial ratio factors such as customer satisfaction that is geared to the particular company at hand.

An effective system for measuring KPI is useful to all functional areas and departments within the organization. KPIs aren’t just related to the accounting/number crunching/financial statement -- i.e. “paper pushing” -- people. When we talk about the need for KPIs, what we’re really saying is that a successful company will benefit from having KPIs for all departmental teams such as Sales, Marketing, Purchasing, Human Resources, Accounting, Accounts Receivable, Accounts Payable, Call Center, Advertising, Help Desk, etc. -- the list goes on.

The bottom-line: the better system you have in place for measuring all manner of KPIs, the better chance you have for success.

“Nothing lasts forever,” as the age-old saying goes. Eventually, ownership and key employees will leave your business, voluntarily or involuntarily, and no longer play a role in the business they worked so hard to create. Integrating an exit strategy into your business plan is crucial in order to achieve long-term goals -- things like having sufficient levels of funds to meet retirement needs. For this reason, selecting your business successor and identifying the method of transfer to the successor are the key objectives of an effective exit strategy plan.

The importance of identifying and integrating your exit plan into your business plan as soon as possible cannot be overstated.

The Importance of Securing Flexibility for Your Future

Catastrophic events can easily occur that will impose unneeded pressures and influence the decision-making process at a less than ideal time. In the world of business the most successful decision makers are those who have the flexibility of options on their side. Waiting until the last minute to formulate some sort of exit plan will work to the business owner’s disadvantage.

Why? Simply put, the number of options diminish over time. It is not a matter of whether you will sell or otherwise dispose of your interest in this business. Those things are a certainty, and the sooner you plan for it the more freedom you will have.

According to a study by Bank of America, as noted in MyOwnBusiness.org, three out of four companies claim to have a succession plan, but less than 40% of those companies implement their plans. For family businesses, the numbers are worse: only 15% of family businesses survive to the second generation. Even less than that survive to the third.

Most, if not all, business transactions have some sort of tax consequences associated with them. Exiting a business is no exception. Timely and careful exit strategy planning will allow you to maintain valuable flexibility when trying to decide on the most advantageous approach on how to avoid, or minimize, the negative tax consequences.    

All of it boils down to a simple question: who is in the driver’s seat when it’s time to leave your business? The ultimate goal of effective exit planning is to maximize the chance that you will leave your business on your terms and under the conditions you want.

Of course, selecting the right exit strategy team (attorney, CPA, etc.) with the proper expertise and experience will go a long way toward securing real flexibility. You should always be the one in the driver’s seat when it’s time to leave your business. However, ensuring that happens requires diligent forethought and a thorough understanding of the possibilities.

Consider the following four ways to leave your business:

1. Transfer Ownership to Family Members,

2. Employee Stock Option Plan (ESOP),

3. Sale to a Third Party, and

4. Liquidation.  

1. Transfer Ownership to Your Children

Transferring a business to your children is the dream of many business owners when contemplating his or her exit strategy. Such a transfer can provide a level of financial wherewithal your children they might not otherwise have.

However, be wary of the following risks:

• This option increases the risk of family discord.

• Financial security may be diminished, rather than enhanced.

• The very existence of the business is at risk if it's transferred to a family member who can't or won't run it properly.

In those cases where a transfer to your children is not realistic for whatever reason, alternative options will have to be considered and formulated.

2. Employee Stock Option Plans (ESOP)

Another alternative is the Employee Stock Ownership Plan (ESOP) -- a helpful way, using the participation of your employees, to maintain control over your exit. As the IRS notes on their site, an employee stock ownership plan (ESOP):

• is an IRC section 401(a) qualified defined contribution plan that is a stock bonus plan or a stock bonus/money purchase plan

• must be designed to invest primarily in qualifying employer securities as defined by IRC section 4975(e)(8) and meet certain requirements of the Code and regulations

• has features over which the IRS and Department of Labor share jurisdiction

• are trusts into which either cash to buy company stock or newly issued stock is placed. Contributions the company makes to the trust are generally tax deductible, and because transactions are considered stock sales, the owner can avoid paying capital gains. 

Some of the advantages of ESOPs include the following:

• The Company can buy out the current owners.

• Employees can share in any stock appreciation.

• An owner gets to keep control until he is ready to retire.

• The company uses the ESOP as a motivating tool.

3. Sale to a Third Party

When you structure the transaction as sale to a third party, the primary benefit is simple: the transaction can be structured in such a fashion that all, or most, of the sales proceeds come to you immediately upon closing in the form of cash.

If the bulk of the purchase price is not paid in cash then the risk complexion of the transaction will be much higher for the seller. For example, crucial funds that he or she would be counting on for retirement would be left in the uncertain control of the buyer. The best way to mitigate this risk is to structure the transaction in a fashion where the seller’s control of his or her funds is immediate and not pending until other variables out of the seller’s control are resolved.  

4. Liquidation

Another option is to liquidate the company. The liquidation process entails the sell-off of the company’s assets and the payoff of outstanding accounts payable and other liabilities. After collecting on all the assets and the payoff of all outstanding liabilities whatever remains goes to the owner.

Watch out for a liquidation scenario whereby the buyer refuses to recognize a market value for the seller’s historical efforts, apart from the value of “hard” net assets. In this case the buyer would likely only pay for the value of the hard net assets, leaving little, or nothing, to fund retirement.

Service businesses are somewhat more troublesome to the selling owner who is trying to “net out” enough cash from the sale to fund his or her retirement. Service businesses are generally viewed as having little value once the owner leaves the business. Thus, the liquidation of a service business tends to produce the least favorable return.

A Limited Liability Corporation (LLC) is a hybrid between a sole proprietorship and a corporation. So, as the owner or partner in an LLC, you are considered self-employed as you would be as a sole proprietor. In an LLC, the business itself is not taxed but its owners are. And like a corporation though, an LLC is protected from having personal assets pursued that are the result of business actions. It’s not recognized as its own entity like a Corporation is an entity however.

Each member in the LLC files their own tax forms. For a single owner, you’d file the same forms as a sole proprietor—form 1040 and Schedule C.  In a partnership LLC, the partners would fill out form 1065. And should your LLC elect to go through the process to classify as a corporation, one form, 1120, would be filed for the corporation.

If deciding between an LLC and an S-Corp, know that an LLC requires much less paperwork, record-keeping and startup costs. There is also a lot more flexibility in how profits can be divided up and shared in an LLC than in an S-Corp.

A drawback to an LLC is that if you’re in a partnership and one partner leaves the LLC, the LLC is immediately dissolved. Also, each member in the LLC and the entirety of the LLC is also subject to Social Security and Medicare taxes.