Small Business Adviser

Break even sales is the amount or volumes of sales that a company must realise in order to match the sum of its variable and fixed costs. (In other words, simply put, this is amount of sales a business must make in order to meet its costs.) If a business’s sales cannot at least match its costs then that business in not viable.

In other instances, a manufacturing business may also be able to determine the break even volume of production or the production capacity that it must operate at in order to break even. Please do not be put off by the formula below as it followed by a very simplified example.

The break even formula is as follows

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Fixed Costs =Breakeven Sales

*Contribution Margin

*Contribution Margin = 1- Variable Costs

Sales

As an example, for 2008 Eld Limited realised sales of $ 5 000 000 and had of fixed costs of

$1 000 000 and variable costs of $ 2 500 000. Eld Limited’s break even sales figure is worked out as follows

Eld Ltd’s contribution margin

1 - $ 2 500 000 = 1 - 0.5 = 0.5

$5 000 000

Eld Ltd’s breakeven sales

$ 1 000 000 = $ 2 000 000

0.5

A banker will be comfortable in dealing with a company like Eld Limited. The company has a sales figure of $5 000 000 but it requires sales of only $2 000 000 to meet its costs. The sales would therefore need to drop by at least $3 000 000 before we can begin ringing alarm bells. There is quite a huge gap of comfort.

However, the situation could have been very different if Eld Limited realised sales of $2 100 000 against a break even sales point of $ 2 000 000. If the sales were to drop by just more than $ 100 000, Eld Limited would be in trouble.

By the same token if a Eld Limited runs a bakery,. it will be possible for management to determine the breakeven sales volume. For example if the bakery must sell the 50 loaves per day just to break even, the banker will be pleased if the actual sales volume is 150 loaves per day than if it is 57 loaves per day. With sales of 57 loaves per day there is a very thin margin of comfort.

Bankers are more comfortable dealing with businesses that has have considerable margins of safety in which to manoeuvre.

There are three main types of mergers which are as follows

(1) Horizontal merger – where two business in the same activity or subsector link up. For example, the merging of two commercial banks.

(2) A vertical merger – where firms in the same industry but located at different points of the vertical activity chain link up. For example,a brewery merging with a company that operates several bars or liquor stores.

There are also two major subdivisions of vertical mergers namely

(i) Vertical forward or upwards integration-for example , a manufacturer taking over a distribution chain or outlet

(ii) Vertical backwards or downwards-a manufacturer merging with a supplier of raw materials

(3) Conglomerate/Diversification – where a company merges with another in an unrelated industry or activity so there is no carry over of specific capabilities. The case of diversification rests on spreading the risk by not having all your eggs in one basket and the advantages of managing firms as individual strategic business units(SBUs) within a portfolio.

Mergers - rationale

The merger may formalize well-established joint ventures or strategic alliances which may already have been in existence.

The potential partners would have done their homework to ensure that the merger allows them to:

Ø Eliminate unnecessary competition and to harmonize operations; thereby cutting costs focusing attention and energy, and combining to unlock value

Ø Combine resources and skills to the best effect

Ø Offset each other’s weaknesses and augment each other’s strength.

Ø Achieve economies of scale

There are also situations where two or more companies may merge in order to pre-empt a hostile takeover bid of one the parties involved. The hope is that the merged company will be more difficult to attack or that the rationale behind hostile takeover bid will no longer hold water.

However, it is pertinent to note mergers may fail if the following factors are ignored.

Guiding Principles

Having guiding principles that are linked to the merger’s strategic intent. They cannot be a merger just for the sake of it. They must be a strategic intent and guiding principles must be developed based on the strategic intent.

Feedback To Stakeholders

All stakeholders must be given information during the formulation, implementation and finalisation. This ensures that no stakeholder group will be surprised with the final product.

Set stretching targets

Stretching targets will help ensure that the integration team will push as far is possible for cost savings and revenue generation.

Clear Financial Benchmarks

There must be clear financial benchmarks built into the merger implementation plan. A very detailed plan which ignores the financial aspects is like having no plan at all.

Merging cultures

A merger may also involve the merging of two groups of employees whose working cultures will be at variance. Ignoring the cultural aspect will be fatal. It is critical that management set a clear vision that is understood by both sets of employees and there must be ‘buy in’ events which must be held as part of the implementation plan.

A merger must be thoroughly thought through to avoid pitfalls.

This measure is key indicator of productivity and operating efficiency.
This looks at the relationship between a business’s resources (its assets) and its net profit. It is one measure that is sometimes used to gauge management performance. The reasoning behind this is that a consistently high return on the business’s assets requires considerable management skill and ingenuity.
The formula is as follows

Net Profit Before Tax
Total Assets

Net profit before tax is the preferred numerator because it eliminates the distortions that can arise from different tax regimes or different tax strategies.
A low or decreasing ratio may ring alarm bells to your banker as this may indicate a lack of proactive management or even unsustainable operations. Where possible, a low ratio can be remedied by generating more sales per dollar of assets.

1. Information. This is basic but many business owners miss this. As much you can be in the habit of keeping data, records and statistics on just about anything relating to your business. You never know what sort of information will help an outsider understand the business.

2. Organized information. Related to 1 above, keep the information in an organized and consistent manner. The information must also be readily available. The information must be go some way in telling the story before you actually open your mouth. There are cases where the business case of a loan proposal is justified but the proposal is rejected merely because of a lack of clear and concise information. In cases where the application is not entirely rejected, unnecessary delays may be experienced as a result of poor information presentation. Further to this, if you are in a sector that has a lot of technical jargon, try to break it down.

3.Positive Mien. When you present your case you must be enthusiastic and sound confident. If you are not passionate about your business, it most likely that the person or people whom you talk to will be not be enthusiastic. You must be able to inject your banker(or any potential financier or partner) with your enthusiasm to the extent that they become your advocates.
4.Outline The Challenges. Do not shy away from talking about the challenges being faced by your business. Clearly spell out the challenges and also outline the strategies that you have developed in dealing with those challenges. Sometimes, your banker may even be in a position to offer alternative strategies based on previous experience. Your banker is unlikely to approve your loan when he discovers that there are risks pertaining to your business that you do not mention or that you are not aware of.
5. Challenge Process. You must be prepared for any queries that may your banker may raise. Before going with your proposal to the bank, give to a trusted colleague or another independent person so that they also provide their opinion or better still raise questions. This will allow you to polish up and better prepare yourself for any questions your banker may have.
6. Know your stuff. You will impress any banker if you display that you know you have ‘hands on” knowledge about your business and that you can answer any query off the cuff. Be in a position to clearly explain the figures, trends and the industry or market factors affecting your business. Even in a situation where you present information that would be prepared for you by a third party ( e.g. Financials prepared by accountants) you must have at least a firm grasp of the meaning of that information and its implications.
Be also very clear about the assumptions behind any projections of future sales, production or manning levels. Also be clear about why you need funding and have an idea about the sort of impetus that the loan will give the business.

What is cost structure? This refers to a business ‘s proportion of fixed expenses in relation to variable expenses.

Variable expenses are those expenses that rise and fall in tandem with sales or production levels. For example product delivery costs or purchase of raw material.

Fixed expenses refers to those expenses that are to a large extent not affected with the variations in sales or production levels. Examples include rent and pay for senior management.

Operating Leverage-a company that has a high proportion of fixed expenses (in relation to variable expenses) is said to have a high operating leverage. Such a company will realise more profits in a situation where volume of production and sales are high than when they are low. This is because it is very difficult to reduce costs related to fixed assets. During the current recession, it is no coincidence that the big car manufacturers needed a bailout from the U.S. government. These companies have high operating leverage arising from the high costs of maintaining the capital intensive assembly plants. Whether or not the production volumes are high or low, these companies will still incur high costs.

In contrast, a company that has low operating leverage has more control of its costs because it has low proportion of fixed costs. Management is in a position to cut the variable expenses when volumes are reduced.

As part of his financial analysis, your banker will also examine the business’s operating leverage and related trends.

The Wells Fargo case as commented on at www.fiercefinance.com is a case in point with regard to unscrupulous practices by bankers.(Refer to previous article on this blog)
See below commentary on www.fiercefinance.com

“Wells Fargo exec’s squat in Malibu hurts bank
By Jim Kim Comment | Forward

Cheronda Guyton, a senior vice president at Wells Fargo, was fired after she took over a fancy home she foreclosed on in Malibu for big parties. The owners were victims of Bernard Madoff. The LA Times ran a huge spread that embarrassed her of course, but more importantly it embarrassed the bank.
CEO John Stumpf, at a meeting with Wall Street Journal and Dow Jones journalists said, “We have very strict controls and policies in place that team members are not supposed to use the properties for personal use. In this case, the person violated those policies and no longer works for the company.” You have to feel for him. At some point, you have to trust your executives to behave. I doubt there’s any “training” out there that would have helped this executive. She will have a hard time finding work in the industry. The PR was that bad.”

For full article visit www.fiercefinance.com

It is noted that most bankers are honest and reliable people but you may encounter some rogue bankers here and there. The aim is to make money by putting the customers in a trap. The rogue banker just like any other crook, will target the most vulnerable members of the community. Some the tactics they use are as follows.

Excessively high interest rates
It is advisable not to agree to interest in the range of 5 to 6% above the prime rate. In most cases such rates will be suicidal on the part of the customer and the banker usually cannot provide legitimate justification for such a high rate

Balloon payments
Avoid facilities with balloon payments. i.e. loan facility where you do not pay monthly principal installments but the whole principal amount becomes payable on maturity date in one lump sum. This is another suicidal arrangement on the part of the small business owner. Payment the loan on maturity in one lump sum will more often that not cripple operations. Furthermore, such an arrangement will enable the banker to mask excessive interest charges. As the result of the fact you will paying only the interest on a monthly basis without monthly instalments of the principal, the interest will be “affordable” so to speak.

Penalty Charge For Prepayment

The financial situation of your business may unexpectedly improve after you take a loan and you want to repay before the loan before it runs its full term. Alternatively, you may want to refinance the loan on better terms after shopping around. Some loan agreements have a penalty for prepayments or early settlement. Loan facilities with such penalties must be avoided.

Banker “Persuading” To Take A Bigger Amount Than You Requested.

Every business person must critically assess his or her situation and then decide on the amount that will satisfy the business’s needs. Don’t think that the lender who encourages to take more than you need is doing you a favour. He will actually be helping himself meet his sales targets but at the same time tying a millstone to the neck of your business. You may struggle to meet to the burden of a larger instalment amount and a huge interest bill.

Huge Upfront Fees

Some loan facilities require that you pay upfront fees. While a nominal figure may be acceptable, fees in the region 4 to 5 % of the loan amount will defeat the purpose of the loan. In addition to the upfront fees, there may be several other payments to be made. You need to ensure that you familiarize yourself with every minute detail of the loan arrangement.

Undue Pressure or Duress

Avoid situations where you are “persuaded” to sign loan forms quickly. You will most likely not take time to read the fine print and this will be to your disadvantage. One well documented dirty tactic is for the client to be made to sign blank forms and your banker later fills in the details for you. Avoid such “favours”

Complex Loans

Never sign loan agreements that have a lot of jargon that you not understand. It is best that you refer to a reputable lawyer for advice.

Collateral Centric Banker

Any reputable banker will grant a loan after considering the viability of your project or business. However, if a banker is only interested in your collateral(either your house, yacht or car) you must open your eyes. The ultimate aim may to be get your assets. Some bankers may through their extended networks be in a position to influence the auctioning process of collateral items for their own benefit.

This is not an exhaustive list of the underhand strategies of crooked bankers. Best of all, in a situation where you are not sure, consult as widely as possible.

There are 2 main types of borrowing need.

1.Short term needs- in this instance, the borrowing facility is used to fund seasonal or temporary requirements. Examples include
-purchasing seasonal inventory: for example , a retailer borrowing to stock up for the Christmas season
-purchasing stock to take advantage of trade discounts offered
-meeting timing differences between expenditure and receipt of funds from debtors.

Short term credit facilities-these are used to finance short needs and they are usually repaid within a period of one year.

Since facility is used to finance short needs, the facility is repaid from cash generated in by a single trading cycle i.e. cash generated from sale of assets or payments received by debtors

2. Long term needs-borrowing facility is used to purchase long term assets or other term needs
Examples include
-purchase of fixed assets such as property or machinery
-Refinance of another long term debt
-Purchase of another business

Since this is a long term facility, it cannot be repaid from funds realized from a single trading cycle. The logic behind this is like this. Taking the example of a manufacturing company that buys machinery to be used in the production of a certain product, the machinery will not be used for just one single trading cycle but it will support numerous trading cycles over a number of years.

There are some business people who usually make the mistake of buying machinery with proceeds from a single trading cycle and hence leaving themselves without any funds to buy new stock or raw materials and the business is then stuck as all the working capital would have been sucked out. Business people are well advised to buy machinery, property or vehicles from additional equity or long term borrowing and not to use working capital.

When companies want to hire people for managerial post they usually list managerial experience as one of the requirements. While experience is vital, a banker will usually carry out comprehensive analysis of managerial ability. The analysis can be broken down into several components. I will begin with experience itself.

Experience

What is it that we mean by 10 years experience? This may mean 10 years of doing the same thing over and over again. Consideration is given to the quality of the experience. For example a banker would prefer a manager who successfully led a company through a recession than one “who goes through the paces” in a normal situation. A manager who leads a company through difficult times and major changes has much more valuable experience.

Breadth

While the company can have an experienced finance manager, consideration is also given to other areas of management such as marketing, human resources and production management. A well balanced management team is more likely to give a company better leadership as all factors are taken into consideration when the team sits down to plan or forecast.

Depth

This relates to whether or not the company has a viable succession plan. Has the management team got a culture of training subordinates with an eye towards the future? The ideal situation would be for the subordinates to occasionally perform managerial duties under management’s mentorship. A company which always fills managerial posts with outsiders is considered risky by bankers.

Integrity

Bankers are sensitive to any whiff of dishonesty. Bankers have an oath of confidentiality and so managers must not have any qualms being frank about all the challenges the company is facing.
Furthermore, there is need for management to conduct their personal financial affairs with uttermost care. Diligent checks on management’s financial affairs and are usually made as part of the business loan application review process.

Labour Turnover

This measures the rate at which employees are leaving a business. The following formula is used.

number of leavers per year x 100
average number of staff

High labour turnover may be a result of
 low morale
 economic growth creating numerous opportunities for workers
 remuneration levels that are not competitive

High labour turnover may affect a business in the following ways

 reduced productivity because a major part of the workforce will always be on a learning curve (there is also a possibility of total production disruption should be the employees resign en masse)
 increased recruitment and training costs
 the business will not be able to build a reliable team

Bankers or financiers in general are not very comfortable dealing with businesses with high labour turnover given the possibilities of reduced productivity or disruptions in operations.