"I'm saving up for a new car," I said, as we
sat
around the Thanksgiving Dinner table a few weeks
ago.
"You're what…?" said 28-year-old daughter
Kate, looking
somewhat incredulous.
"Well, I just made the last loan payment on my car,
and I told
the bank to take the same monthly amount out of my
checking
account and just stick it in a special savings account
that I set
up for my next car, which I'll probably buy in another
four
years," I responded.
Car conversations in the Howe Family are notorious
for starting
fast and going nowhere. We speculate in
automotive
futures: how long will this one last? Does a ball
joint
replacement at 50,000 miles portend a sudden
downturn in the
market for the car? When does "good" car repair
money begin
to go "bad"?
With cars for my wife, Annie, and me plus those of
five adult
"kids" and three spouses adding up to ten, there's
always
family conversation to be had on the subject.
But "saving
up for…" — ? Never. It's an idea that
they left
behind in childhood when, for most of them, it never
emerged
from the concept stage.
In similar fashion, several of my smaller company
clients, to fund a new piece of equipment, or to
install the
latest "enterprise" software system, or to undertake
a plant
expansion, now feel that they're in the happy
circumstance
of just "dialing for loan dollars." Who needs a
savings
account when banks and leasing companies will take
your loan
application over the phone, confirm it by email, close
the deal
by fax, and wire to your operating account 70, 80, or
even 90%
of your project's cost?
Is "saving up for" passé?
A lot of entrepreneurs seem to think so. Many of
them
— or their controllers — have gone to
school to
learn just enough number-crunching to be dangerous.
In
Finance 101, they were taught to calculate an IRR
— an
Internal Rate of Return — on their capital
investments.
They know the key financial question: can we
make
enough money on this new machine to justify the
purchase?
In many cases they, or their finance person,
can quickly
do the analysis:
(a.) Total outlay, including interest and principal
on the
money employed (not just the borrowed cash), plus
closing
costs and financing fees, plus installation and
training, plus
incremental operating costs
– divided into –
(b.) Some combination of the annual net profit
from the
incremental sales (if the equipment increases
capacity) or from
the improved productivity/greater efficiency that
results in
better margins.
If the result exceeds 50%, which indicates a two-
year
payback period or less, the answer almost always
is "Go." If
it's less than 33%, which means waiting for more
than three
years to recoup the investment, the decision
generally is
"No." A result that lies between the two usually
brings
non-financial criteria into the decision process.
But, these days, once you pass "go" you seldom
hear "no"
when it comes to financing, assuming that
you've been at
least moderately profitable and your balance sheet
shows
positive net worth. Some leasing company or some
equipment
vendor somewhere will advance most of the funding
for the
capital acquisition, perhaps without even asking for
projections
to see if the presumed new profits can cover the
increased
debt service.
The argument for borrowing to buy is simple: pay
for the
new asset out of the additional money that is earned
from
acquiring it and putting it to work. In the best
case, that's
the way it goes: spend $100,000, finance over three
years,
earn an additional $50,000 each year (50% return on
investment), and the cash flow covers the debt
service nicely,
even at a 10–12% rate of interest.
But — then — there's the "What
if…?"
…the incremental sales don't happen.
…the installation and the training/learning cycle
stretch
out for a whole year.
…the expected efficiencies just aren't there.
…the competition acquires the same equipment,
gets the
same new efficiency, and lowers the price, wiping
out the
anticipated gain.
…or — even if — revenues, and
then
receivables, jump substantially and you become
pressed for
working capital to fund the growth.
Here's where there's no substitute for cash.
Life in
the fast lane of small business is potholed by "What
ifs." Even
the best planners can't avoid some of them.
Capital
budgeting is not simply a process of setting a
50% hurdle
rate and calculating an ROI on each investment.
Rather, it
is an integral part of an operational budget, one
which
plays out the financial implications of multiple
scenarios
— especially on the downside — to
determine
what happens to cash when debt service goes up
and profits do
not follow.
So don't think about 2006 just in terms of sales and
expenses.
After you have figured out your capital budget
(see "Draining The Swamp" below, for more on this
topic), take the
analysis a few steps further to determine what
happens to cash
in multiple situations, upside and downside. Set a
cash
balance target — a savings plan, if you
will
— to ensure access to enough cash to equal a
month's
payroll, or a month's payroll plus a month of overhead
costs,
and maybe two months of debt service. Then
stick to the
plan — after all, you're saving up
for what
you can afford…
And if you can't afford it, don't buy it.
