Survive over the long term.
January 2018 Vol. 7 No. 1

"Cost of capital" refers to the minimum return investors expect for providing capital to the company. In order to survive over the long term, and despite whatever profits you earn, your business needs to earn more than its cost of capital. 

In today's newsletter I explain why, and offer suggestions for managing this important measure.
All the best,

Charlie Goodrich
Founder and Principal
Goodrich & Associates
In this issue...
How to Earn a Profit and Still Go Out of Business - Earn less than your cost of capital

Several years ago, I was attending the presentation of an individual who oversaw high yield investing (and a whole lot more) for one of the largest asset managers in the world. During his talk, word of a "Chapter 22" (a company filing for bankruptcy a second time) came out.

He commented: "High yield bonds and distressed investing as a career is a great choice. Larger companies that leave bankruptcy often can't make more than the cost of capital, so they eventually file again. Study the company once and invest. Then wait a bit and invest again on the second filing, because you already understand the company."

What did the speaker mean?

Simply said, if true profits are $10 million and the true cost of capital is $12 million, the company, despite earning a profit, is digging a hole. Eventually, something gives and the company goes under.

What is cost of capital?

I have discussed this before at length, but essentially, it is the minimum return investors expect for providing capital to the company. In other words, it is the weighted cost of all debt and equity.

So, for example, if a company is financed with 60% debt in the form of a bank loan and 40% equity, then that company's cost of capital is .6 X the cost of debt plus .4 X the cost of equity. (For the not so simple answer, read that newsletter!)

But, hold on... my company earns a small profit. We have positive EBITDA and cash flow. Doesn't that mean we are OK? Often, it doesn't.

Accounting profit differs from economic profit in an important way: Economic profits are after the cost of equity. Accounting, or GAAP profits, are before the cost of equity. Accounting profit is simply a measure of the return, if any, to shareholders and says nothing about whether that return exceeds the cost of capital (and shouldn't, for a variety of reasons). Further, just generating cash flow does not mean you are generating an economic profit - cash flow may not be enough to reward equity holders the return they expect.

Of course, measuring economic profits is easier said than done. After all, what is your cost of equity and what is today's market cost of debt? In any case, there are red flags that you may be digging an "equity hole." Your business may need capital equipment and upgrades it can't afford, resulting in more down time, quality problems, etc. You may be behind on product upgrades, safety training and so forth.

In each of these cases, a lack of cash is the culprit. And the most common reason for a lack of cash is that the business is not earning enough to cover its cost of capital - there are not enough profits.

Sometimes I hear CEOs and CFOs of privately held companies moan that the owner is taking too much out of the company - hence these critical spending shortfalls. But that "too much" is your cost of capital. The owner is indeed getting his return on capital, for now. Until he sells that is, or eventually becomes non-competitive and spirals downwards.

Different types of expensive capital

What about those expensive forms of capital such as factoring, or even private high risk/high cost debt? Do they ever make sense? Sometimes, yes. Particularly, if you are funding an investment opportunity with a high potential return. Typically, there is insufficient equity in these situations for more conventional, lower cost debt financing. So, the higher risk debt is really picking up some of the equity risk.

Not long ago, I met a CEO of a company that had been trying to raise capital, equity and some junior debt so his business could continue growing. He has debt financing from a factor (not cheap). Why does this expensive debt make sense? Because the business is in a "hot" growing sector with proprietary technology and many big-name customers. In the short term, he can't earn the cost of capital (I suspect he is treading water). But in the long term he will.

I called the CEO recently and asked how a potential new investor was moving along. Things are good, he said, but the investor's due diligence is dragging. He went on to say that the lender's attitude towards him was great, as it should be. The factor advanced about 95% of working capital. The factor can't get paid in full by liquidating the assets. This lender's surest way out is for the company to complete the equity and junior debt financing, thereby allowing the company to grow at lower risk levels so a more conventional lender will pay him back. Why did the lender advance so much? Because the enterprise value is there. The expected return on capital in this situation is very high.

With expensive junior debt, what often makes it expensive are the warrants - basically options to buy stock if the company is sold for a big price. This investor knows the company can't survive by paying him his needed return every year. So instead he waits - and gambles - for a big payout in the end.

What does all this mean for you?
  • Don't delude yourself with meager profits. Profits need to exceed your total cost of capital, equity included.
  • Know your cost of capital. (Click here for suggestions on how to do this.) Modern financial theory assumes you are paying market costs for your capital and it is rare you will pay less than that. But, if you don't know what you are doing when you finance your company, you can certainly pay more.
  • Be properly capitalized. Yes, financial theory says there is no optimal cost of capital. If you have lots of lower cost debt, your cost of equity is higher. If you have wads of equity, then your debt cost is lower. And while this is more true than not, this academic view looks at snapshots in time - the cost for a moment. Equity, in terms of economic value, not just the accounting records, provides staying power.
  • If you are a lender with a creditor in default, be careful about collecting fees and default interest as you may diminish the enterprise value. As I have mentioned before, liquidations often return less than the nominal value of collateral. So, a sale as a going concern may be a better way out.
Here's the bottom line. In order to survive over the long term, your business needs to earn more than its cost of capital. Absent that, the fun times are sure to end soon.
Please share with your colleagues
Heard on the Street

There is a lot of noise about rising income inequality. So what?, argue Bruce Meyer and James Sullivan, professors from the University of Chicago and the University of Notre Dame respectively.

What matters they say is consumption inequality - that includes government transfers (handouts) - a measure that has been pretty stable for the last 50+ years.

To find out why consumption is a better measure of inequality read their short article here.

About Us

Goodrich & Associates is a management consulting firm. We specialize in helping our business clients solve urgent liquidity problems. Our Founder and Principal, Charlie Goodrich, holds an MBA in Finance from the University of Chicago and a Bachelor's Degree in Economics from the University of Virginia, and has over 30 years experience in this area.

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