“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” passÃ©?
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.
Draining the Swamp
One of my clients recently purchased a laser system for particular use in marking its products as a back up to a primary laser system which is approaching capacity on two shifts plus overtime.
If capacity is reached, or if the primary system is out of service for any length of time, the alternative is to sub-contract the work at a piece rate plus a $50 lot charge. The cost of new equipment is $60-80,000; the client found a suitable used machine at $22,000 and calculated the payback as follows:
|Base cost (used) w/ delivery||$22,000|
|Installation, set-up & training||1,500|
|Cost of capital (3 yrs. @ 8%)||5,280|
|Unit production cost (inside):|
|Max. utilization||a.||100 units/hr.|
|Labor rate/hr. w/ overhead||c.||$45.00|
|Cost per piece:|
|Labor & overhead (c/a)||e.||$ .45|
|Total inside cost, all units (d*e)||f.||$49,500|
|Unit production cost (outside):|
|Average lot size||g.||200 units|
|Total lots (d/g)||h.||550|
|Per lot charge||i.||$50|
|Lot costs (h.*i.)||j.||$27,500|
|Unit cost, outside||k.||$.50|
|Total unit costs at 110K (d * k)||l.||$55,000|
|Total outside cost (j + l)||m.||$82,500|
|Annual Savings (m – f)||n.||$33,000|
|Payback period: $29,800 / $33,000 = .903 years|
|Payback period in months = 12 x .903 = 10.8 months|
According to Nicholas Carr, former Executive Editor of the Harvard Business Review, a 1998 study by accountants KPMG surveyed 1,450 companies and found that “three-quarters said that their IT projects exceeded their deadlines and more than half said that the projects went substantially over budget.” In fact, 87 of 100 selected failed initiatives “had gone over budget by more than 50 percent.”
Carr goes on to say, “Many of the failures were, in retrospect, inevitable, a natural consequence of the process of trial and error that goes on as any new technology is adopted by business… The challenge now is to bring the failure rate down” by putting the IT house in order.
“Most companies can reap significant savings by simply cutting out waste. Personal computers provide a good example. Businesses purchase more than one hundred million PCs every year, most of which replace older models. Yet the vast majority of workers who use PCs rely on only a few simple applications – word processing, spreadsheets, e-mail, and Web browsing. These applications have been technologically mature for years; they require only a fraction of the computing power provided by today’s microprocessors. Nevertheless, companies have continued to roll out across-the-board hardware and software upgrades, often every two or three years.” [emphases added]
– An excerpt from Does IT Matter? Information Technology and the Corrosion of Competitive Advantage, by Nicholas G. Carr. For the complete excerpt, click here.