February 29 is a date that usually occurs every four years, and is called leap day. So you have one more day available in 2012. How many times have you said, “If I had just had one more day in a week, month, I would do (blank)”? The opportunity is available to you during this month of February. So what could you do?
Let’s look around to see if you’re ignoring any basic principles that can maximize your business value and your personal net worth. The objective in strategic wealth management is to integrate your business plan with your personal financial plan together to arrive at your life-plan goal. Too often, business executives and owners treat their personal goals separate from their business goals, operating each in a vacuum. Different sets of criteria are used to evaluate achievements in both business and personal arenas, and this further polarizes the strategies, causing a disconnect in achieving your ultimate financial and life-plan objectives. What risks are inherent in your personal and business portfolios? Do you take risk in business and therefore choose not to take personal risk in your portfolio?
Rather than obsess and concentrate on more ways to reduce taxes, are you “missing the mark” in utilizing key financial metrics to measure the financial success of your businesses?
Let me introduce the financial metric use of excess cash. When is too much cash a problem?
How a company’s cash is managed is a critical job that most business owners do from an emotional perspective rather than a rational financial one. Poor cash management can harm the company’s performance in subtle ways as well as more obvious serious ways. It is not having too little or no cash — it is also having too much cash as well. It lowers the return on assets and it increases the cost of capital (just like increasing the cost of goods without an offsetting increase in the customer pricing).
Holding excess cash lowers return on assets, increases the cost of capital, increases overall risk by destroying business value, and commonly produces overly confident management. When the cash balance exceeds the actual working capital cash balance need, you have excess cash. This cash is not necessary to the firm’s financial operations. Increasing or decreasing excess cash balances is a leading indicator of future good or bad times for the company. When there is too much negative excess and decreasing cash generation, cash needs to be accumulated, but when there is excess cash balances and increasing cash generation, the excess cash needs to be invested or distributed. Let’s take the effects of excess cash one item at a time.
Let’s look first at the effect of excess cash on the return on assets (ROA). Assume a business has total assets of $1 million with cash making up 15 percent of the total assets or $150,000. Further, assume that the business has an annual after tax net income on an adjusted debt free basis of $100,000. That would result in the business having an overall ROA of 10 percent. If the business is only earning 2 percent annual interest on its portion of the total assets then the real effect of cash can be determined. In this example it is assumed that all of the cash is excess in order to illustrate without too much complication.
If the return on the cash is only 2 percent and the overall ROA is 10 percent then one would have to assume that the ROA would be higher if the cash could be eliminated from the total assets. When the cash is eliminated the total assets go from $1 million to $850,000. One more thing to look at: the interest income on the cash is now eliminated so the net after tax income needs to be removed. This would be around a net after tax interest income of $2,000. The total net income after tax now comes to $98,000 and that amount divided by $850,000 results in a new ROA of 11.53 percent, which is 15 percent higher than the original ROA.
Warren Buffet strives for a 15 percent return on his businesses — 15 percent on what? He is striving for a net 15 percent book value return on his equity. The remainder above the 15 percent, he distributes to shareholders. So if you had your financials analyzed, and you had excess cash flow, what would you do with the distribution? What about funding a pension/profit sharing plan, deferred comp for you, defined benefit plan, or other plans that now directly link to your retirement objective? Interestingly, the less excess cash retained in your business the greater the value you are building within your company. The greater the value you build, the closer your retirement goals come to being a reality.
Our Business Ferret report provides substantive numbers to lenders, shareholders, and the like to perpetuate the strategic growth. Bankers/lenders now will receive specific numbers assisting you in the process of properly using excess cash. Other stakeholders are now receiving distributions that incent them to drive value and company performance. For more information about the Business Ferret report please visit the business owners section on our website at www.ravfinancial.com.
Happy Leap Year.