Accounting Accidentally: May 2013

Wednesday, May 1, 2013

The Two Ways You Raise Money to Run Your Business (Capitalization)

There are two ways to raise money to run your business: equity and debt. You can sell ownership in your business by issuing stock. The stock purchaser is an owner of your business. On the other hand, you can issue debt. The other party is a creditor- not an owner. Now, finance has become pretty complex over the years. But the stock or debt decision still remains.

A professor I had described a banker as someone who checks the floor on all fours sides of the bed before getting up in the morning(!) It’s a nice visual that refers to the fact that bankers should be cautious people. After all, they are lending someone else’s money- not their own.

Commercial bankers are those that lend to businesses. They want to make sure that the company/ borrower has sufficient earnings to pay the interest on the loan, as well as the principal. So, your firm needs to have some “room” in your income statement. If your company takes out a loan, it wil have an additional expense for interest. There’s also a cash flow issue: the company needs enough excess cash to make interest and principal payments over the life of the loan.

Now, a company borrows money for a specific purpose. The goal is that the rate of return (profit) generated by the loan will more than cover the interest expense. If you borrow money for a new machine, maybe you can produce more product than the old one. If you produce and sell more product, your earnings can increase. If the increase in earnings is more than the interest expense of the loan, you’re financially better off.

Consider your cash flow. If you produce and sell more product, you’ll collect more cash. If the addition cash you collect is more than the principal and interest cash payments, you have more cash.

Ideally, our cautious banker would love a company that doesn’t have much existing debt- which means they don’t need much extra earnings (or extra cash) to make interest and principal payments. The banker would love a company with increasing revenue and earnings.

Which brings us to Apple Computer.

A recent Wall Street Journal article (“Apple's Record Plunge Into Debt Pool”, 5/1/13) explains the huge public interest in buying Apple’s recent debt offering. In fact, the article explains the “$17 billion offering investors hungrily gobbled up”. It was Apple’s first bond offering in 20 years.

“The technology company as able to borrow at rates nearly as low as the highest triple-A rated firms in the world”. Triple-A is the highest rating issued to companies that borrow money. A very small percentage of companies have a triple-A credit rating.

Bond rating companies give Apple a AA+ rating, based on “excellent liquidity and significant net cash balances”. In other words, Apple has a large number of assets that they could sell for cash- or convert to cash quickly (liquidity). Those assets include current assets, like accounts receivable. Apple also has huge cash balances. In fact, they issued the debt to finance cash needs in the U.S. Much of Apples cash is overseas. Apple issued the debt, in part, to avoid taxation on needed cash they might move from overseas.

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Ken Boyd

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When the Outsourcer Starts Outsourcing (Make vs. Buy Decision)

Outsourcing can be defined as hiring an outside vendor to produce a product or service. This involves a make vs. buy decision. Is it cheaper to produce the product yourself, or pay an outside vendor to make the product for you? A few tips regarding make vs. buy:

If you make the product yourself, you’ll incur the variable costs (mostly labor and materials) to make the product. If you’re making blue jeans, for example, you pay for denim material costs- and for labor costs to cut and sew the blue jeans.
When you consider outsourcing, the purchase price charged by the outsourcing company is part of your total product cost.
If you choose to outsource, some of your fixed costs may be eliminated. For example, you may not need certain employees that were managing production. However, you may not get rid of all fixed costs. If you have a long-term lease for a factory building, you may have to continue payments- even if production stops.

While it may be cheaper to outsource, there are other considerations. The outsourced product needs to be of good quality- and completed on time. If not, your production process may slow down (while you wait for the outsourced product). If you ship a poor quality product (or product component) to a customer, the product may not work correctly. That issue can upset your client.

For decades, companies in the U.S. and Europe have outsourced production to China. The outsourcing made economic sense, because the labor rates in China were far less than those in other parts of the world. Now, that’s changing.

A recent Wall Street Journal article, (“China Manufacturers Survive by Moving to Asian Neighbors”, 5/1/13), reports that after “decades of nearly 20% annual wage increases in China”, production is leaving the country. Rather than continue production in China, companies like Nordstrom and Crocs are moving to Vietnam- where labor costs can be 50% of the Chinese rate.

In many cases, The Chinese company keeps responsibility for producing the item. They simply outsource the physical production to a country with a lower labor cost rate. It’s an example of an outsourcer doing some outsourcing(!)

One last thought: If production is leaving China, how does China replace those jobs? Like other countries, China is attempting to move to higher skill, higher wage industries. It’s a trend that you see in many countries as they develop economically. Instead of manufacturing the next great product innovation- Chinese companies want to create the concept- and manufacture the product somewhere else.