How Much is Enough?
Thomas C Schleifer, Ph.D.
In this first series of messages for 2023 we’re looking at how to professionally manage a construction firm’s capital position to ensure enough liquidity to see the firm through an inflation/recession economy that can threaten reliable cash flow. The amount of money required to run a business varies by company and industry. For a closely held construction company, the exposure is that it can cease operations very quickly if it runs out of cash and credit.
For the closely held company maintaining liquidity inevitably means borrowing. Borrowing, however, increases liabilities with a resultant change in the liabilities to assets ratio. The amount of investment in the company held by outsiders (banks) goes up, while the investment of the owners of the company goes down. The company is at greater financial risk because it is less self-sustaining.
Professionally managing your company’s capital position begins with recognizing that there’s a difference between net profit and available net profit. Funds generated from profits are not entirely available for other uses because a portion must be dedicated to maintaining continuing operations, replacement of assets, and productivity improvements to remain competitive in an ever-changing industry. The portion of profits that must remain in the business to maintain the company’s liquidity will vary between individual firms but is approximated by subtracting from the net profit margin the proportion that liabilities represent in the liabilities to assets ratio. At 1 to 3, for example, a conservative approach would be to allow one-third of the profits to remain in the operation to support ongoing business. The balance of liabilities to assets is a measure of long-term liquidity, and a certain portion of profits is needed to replenish assets and retire liabilities in the near term to maintain the balance. This portion of profits might be referred to as “unavailable profit.”
I define available profit (AP) as the portion of profits that can be taken out of the company or applied to business expansions without materially affecting the financial foundation of the firm during ongoing operations. The measurement of AP is accomplished by reducing the total profits by the proportional amount of liabilities in the liability to asset ratio or the total liabilities divided by total liabilities plus assets. The formula for AP is:
AP = (1 – NP/S – (10 (TL/(TL + TA) ) X (NP / S)))
Where NP/S is net profit/sales, TL is total liabilities, and TA is total assets.
Real Earning Power
The earning power of a company, therefore, is not simply determined by its profit ratio to sales. The “real earning power” (REP) of the company can be determined by multiplying the AP by the asset turnover ratio of sales to total assets (S/TA). The formula for REP is:
REP = (AP) (S/TA)
Where AP is available profit and S/TA is sales/total assets.
The financial well-being of the company is determined by using the company’s own financial performance, turnover rate, and debt structure.
I call the resulting computation of risk, the R-Score formula.
The R-Score formula is:
R = (Available Profit) X (Real Earning Power) X (Debt Structure)
And can be used as:
R = (1 – NP/S – (10 (TL/ (TL + TA)) (NP/S)) (S/TA) (TL/E)
Where R is risk factor and TL/E is total liability/equity.
How Much is Enough?
The R-Score formula was tested on a statistically significant number of failed construction organizations for the three years prior to failure and for successful companies for the corresponding three-year period.
- R-scores of the failed companies were positive numbers typically from 10 to as high as the 90s. The R-score was always the highest in the year prior to failure.
- R-scores of successful companies, on the other hand, were much lower, ranging from a fraction less than 1 and most below 9
A summary of the test scores suggests:
- Scores below 5 indicate low risk of failure.
- Scores between 5 and 7 indicate moderate risk.
- Scores between 7 and 9 indicate that financial resources are getting thin.
- Scores above 9 indicate high risk.
Once you truly recognize the difference between profit and available profit, you will appreciate how useful the R-Score calculation is in predicting the liquidity your firm requires to survive the inflation/recession market that so many predict we will be entering. You will find a thorough treatment of the R-Score and how to use it in, The Secrets of Construction Business Success. An R-Score Calculator can be found on the Simplar Website at: https://simplarfoundation.org/blog/.
Prudent construction professionals will take the time to discuss the nuances with their CFO and initiate a program of capital management that will protect the health of their firms as we emerge from a “post-pandemic” world.
Next week we’ll discuss what to do when your R-Score speaks to you.
For a deeper look into the R-Score, read more here: THE R-SCORE
For a broader view into financial management, read more here: FINANCIAL MANAGEMENT
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