Understanding Business Accounting For Dummies, 2nd Edition (122 page)

Increases in the value of their ownership interest in the business

In contrast, lenders are paid a
fixed
rate of interest on the amount borrowed. This fixed nature of interest expense causes a
financial leverage
or
gearing
effect that either benefits or hurts the amount of profit remaining for the equity investors in the business.

Financial leverage refers in general to using debt in addition to equity capital. A financial leverage gain (or loss) refers to the difference between the earnings before interest and tax (EBIT) that a business can make on its debt capital versus the interest paid on the debt. The following example illustrates a case of financial leverage gain.

Your business earned £2.1 million EBIT for the year just ended. Your net operating assets are £12 million - recall that net operating assets equal total assets less non-interest-bearing operating liabilities (mainly creditors and accrued expenses payable). Thus your total capital sources equal £12 million. Suppose you have £4 million debt. The other £8 million is owners' equity. You paid 8 per cent annual interest on your debt, or £320,000 total interest. Debt furnishes one-third of your capital, so one-third of EBIT is attributed to this capital source. One-third of EBIT is £700,000. But you paid only £320,000 interest for this capital. You earned £380,000 more than the interest. This is the amount of your pre-tax
financial leverage gain
.

Three factors determine financial leverage gain (or loss):

Proportion of total capital provided from debt

Interest rate

Return on assets (ROA), or the rate of EBIT the business can earn on its total capital invested in its net operating assets

In the example, your business earned 17.5 per cent on its net operating assets (£2.1 million EBIT ÷ £12 million total net operating assets). You used £4 million debt capital for the investment in your net operating assets, and you paid 8 per cent annual interest on the debt, which gives a favourable 9.5 per cent spread (17.5 per cent @nd 8 per cent). The 9.5 per cent favourable spread times £4 million debt equals the £380,000 leverage gain for the year (before tax).

Business managers should watch how much financial leverage gain contributes to the earnings for owners each year. In this example, the after-interest earnings for owners is £1,780,000 (equal to EBIT less interest expense). The £380,000 financial leverage gain provided a good part of this amount. Next year, one or more of the three factors driving the financial leverage gain may change. Savvy business managers sort out each year how much financial leverage impacts the earnings available for owners.

A financial leverage gain enhances the earnings on owners' equity capital. The conventional wisdom is that a business should take advantage of debt that charges a lower interest rate than it can earn on the debt capital. Looking at the bigger picture, however, the long-run success of a business depends mainly on maintaining and improving the factors that determine its profit from operations (EBIT) - rather than going overboard and depending too much on financial leverage.

Develop Better Financial Controls

Experienced business managers can tell you that they spend a good deal of time dealing with problems. Things don't always go according to plan. Murphy's Law (if something can go wrong, it will, and usually at the worst possible time) is all too true. To solve a problem, you first have to know that you have one. You can't solve a problem if you don't know about it. Managers are problem-solvers; they need to get on top of problems as soon as possible. In short, business managers need to develop good
financial controls
.

Financial controls act like trip wires that sound alarms and wave red flags for a manager's attention. Many financial controls are accounting-based. For example, actual costs are compared with budgeted costs or against last period's costs; serious variances are highlighted for immediate management attention. Actual sales revenue for product lines and territories are compared with budgeted goals or last period's numbers. Cash flow from profit period by period is compared with the budgeted amount of cash flow for the period from this source. These many different financial controls don't just happen. You should identify the handful of critical factors that you need to keep a close eye on and insist that your internal accounting reports highlight these operating ratios and numbers.

You must closely watch the margins on your products. Any deviation from the norm - even a relatively small deviation - needs your attention immediately. Remember that the margin per unit is multiplied by sales volume. If you sell 100,000 units of a product, a slippage of just 50 pence causes your total margin to fall £50,000. Of course, sales volume must be closely watched, too; that goes without saying. Fixed expenses should be watched in the early months of the year to see whether these costs are developing according to plan - and through the entire year.

Debtors' collections should be monitored closely. Average days before collection is a good control ratio to keep your eye on, and you should definitely get a listing of past-due customers' accounts. Stock is always a problem area. Watch closely the average days in stock before products are sold, and get a listing of slow-moving products. Experience is the best teacher. Over time you learn which financial controls are the most important to highlight in your internal accounting reports. The trick is to make sure that your accountants provide this information.

Minimise Tax

The first decision regarding tax concerns which type of legal ownership structure to use for carrying on the activities of the business, which is discussed in Chapter 11. When two or more owners provide capital for the business, you have two basic choices:

A
partnership
- a specific contractual agreement among the owners regarding division of management authority, responsibilities, and profit

A
limited liability company
, which has many characteristics of a partnership but is a separate legal entity, like a corporation