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Newsletters – Cover Your Assets
Metrics to Watch in Creating Company Value
There have been several in-depth studies that analyzed the financial performance of hundreds of companies around the world. Insights were provided by these companies into the key metrics and strategies used by the best performers. The following were found to be the most sustainable value creators, and where focus is concentrated in those companies successfully creating value. The key numbers to watch are:
- Sales
- Net income
- Cash flow from operations
- Total assets
- Total liabilities
- Total equity
Using these six key numbers, four ratios are tracked and trended:
- Asset turnover (revenue/assets)-the higher the turnover, the better utilization of assets experienced.
- Profit margin (net income/revenue)-the greater the margin, the more profits available to fund growth.
- Cash-flow yield (cash flow from operations/net income)-the higher the yield, the more success enjoyed in managing working capital (ie., current assets minus current liabilities).
- Debt-to-equity (total liabilities/total equity)-the higher the ratio, the more of other peoples’ money (leverage) being used to finance growth.
Successful organizations do well on all these numbers. If you are not doing well on the ratios, then drilling down into the six key numbers is needed.
The entire management team needs to understand how the ratios and underlying key numbers connect to value creation.
Standards of performance can be created by looking at historical numbers over time, which will reveal ranges and trends. Then look for comparable measures within your industry to see how you fare against industry peers. Follow this up by setting some annual targets for 1 to 5 years. In other words, “do what the big dogs do” whether you are local or national in scope, and whether you are for-profit or not-for-profit.
This sets the discipline for making good decisions with the goal being to achieve outstanding long-term return on investment.
Your present performance measures may have defects; and there may be no quick remedies. CFO-Pro can provide a strategic perspective on your financial performance measures. If you are interested in connecting the strategy of your company with the financial reports, and to speak to how your company intends to create value, please contact me directly at jlafferty@cfo-pro.com or 630-269-7646.
How Properly Managed Cash Flow Strengthens Businesses
By accounting standards cash-flow cycle is defined as the number of days from a decision to produce a product (or render a service) to the date money is actually received from selling the product or service.
During the cash-flow cycle, the company’s bank account fluctuates from a deficit to a surplus level.
The cycle starts when materials, labor and overhead are purchased. The purchase creates a simultaneous accounts payable and inventory. The next step turns inventory into finished goods which are sold to customers. If the sale is on credit, an account receivable will be generated. The final step of the cycle is collecting the receivable and receiving the funds.
If money is paid out on the tenth day and money is collected on the fortieth day, the cash flow cycle is 30 days. Typically, a bank credit line is established to finance this 30 day time factor. As production continues, the cash-flow cycle repeats over and over again.
Management actions may change the time factor. For example, granting more lenient credit terms and paying bills sooner can increase the time factor. A growing time factor could be a danger signal if not properly managed. In contrast, if management creates more stringent terms by requiring cash, cash deposits or installment terms cash flow can be increased.
The cash-flow cycle is intensified if a company’s business is seasonal. During slow periods, firms in seasonal businesses try to control costs and limit losses. However, fixed costs must be paid.
The cycle can be further disturbed if the profitable months do not outweigh the loss months. If lenders lose confidence in management’s abilities, credit lines will be cancelled.
Cash-flow cycles are a business reality. They lead to trouble only when sales are highly seasonal or when annual cash flow is negative.
The first step in effective cash flow management is to schedule out, on a monthly or weekly basis, anticipated cash receipts and cash disbursements. The difference between receipts and disbursements equals cash flow. When cash flow is positive, funds are flowing into the company; when cash flow is negative, funds flow out.
Cash flow and profit are not the same. Profit is the difference between sales and cost. The one major difference is this: cash flow considers only money actually entering or leaving the company, while profit is calculated without considering whether funds have actually been received or disbursed.
More businesses fail because they have lost sight of their cash-flow challenge or because they have lost the faith of their lenders than for any other single cause. In the current economy with a tighter credit market, failures are even more likely.
The confidence of lenders or investors can be regained by establishing a sound cash flow management process. If you are interested in evaluating your business’ cash flow management process to determine if there are opportunities to increase cash flow please contact me directly at jlafferty@cfo-pro.com or 630-269-7646.
The Wisdom of Henry Hazlitt (1894 – 1993)
There are always any number of schemes for saving the X industry (The X industry is one that is obsolete, for example the Horse and Buggy trade). One such contention is that the X industry is already “overcrowded”, and to try to prevent other firms or workers from getting into it. Another proposal is to argue that the X industry needs to be supported by a direct subsidy from the government.
Now if the X industry is really overcrowded as compared with other industries it will not need any coercive legislation to keep out new capital or new workers. New capital does not rush into industries that are obviously dying. Investors do not eagerly seek the industries that present the highest risks of loss combined with the lowest returns. Nor do workers, when they have any better alternative, go into industries where the prospects for steady employment are least promising.
Similar results would follow any attempt to save the X industry by a direct subsidy out of the public till. This would be nothing more than a transfer of wealth or income to the X industry. Taxpayers would lose precisely as much as the people in the X industry gained.
It is equally clear that other industries must lose what the X industry gains. They must pay part of the taxes that are used to support the X industry.
The result is also that capital and labor are driven out of industries in which they are more efficiently employed to be diverted to an industry in which they are less efficiently employed.
If the X industry is shrinking or dying by the contention of its friends, why should it be kept alive by artificial respiration? In order that new industries may grow fast enough it is usually necessary that some old industries should be allowed to shrink or die. In doing this they help to release the necessary capital and labor for the new industries. If we had tried to keep the horse-and-buggy trade artificially alive we should have slowed down the growth of the automobile industry and all the trades dependent on it.
Paradoxical as it may seem to some, it is just as necessary to the health of a dynamic economy that dying industries be allowed to die as that growing industries be allowed to grow. The first process is essential to the second.
— Paraphrased From Economics in One Lesson (1946)
Using Z-Score Predictor
The media reports we’re experiencing the most unusual economy in 40 years. Interest rates are low, however banks are reluctant to lend; hence stalling the contribution of our nation’s small businesses. A growing percentage of home owners are upside down on their mortgages and struggling to find the motivation to pay their debt since there appears to be no benefit to them. Education costs are exorbitant and our students are saddled with school debt. Unemployment is 11%. Although these trends have been developing for years, businesses and consumers alike ignored the facts and continued to spend freely. What is there to learn from the wisdom of 40 years ago and how can we apply it to the reality of today’s situation?
What is there to learn from the wisdom of 40 years ago and how can we apply it to the reality of today’s situation?
Altman’s Z-Score Insolvency Predictor
Edward Altman (1941 – ) presently Max L. Heine Professor of Finance at the Stern School of Business, New York University created the Altman Z-Score in 1968. Professor Altman combined a set of 5 financial ratios to determine, with tremendous accuracy, which businesses would flourish and which businesses could be headed for bankruptcy.
The Z combines a set of five financial ratios. It uses statistical techniques to predict a company’s probability of failure using eight variables from a company’s financial statements.
The Z-Score formula can be applied to publicly traded competitors, acquisition candidates, suppliers, customers, and other companies of interest. The Z-Score may also be useful for establishing trends in the financial condition of your own company. Sometimes a Z-Score analysis is needed to convince management and board of directors of the seriousness of a company’s condition so that turnaround efforts can be initiated.
Here are the 5 ratios and their respective weight factors:
| Ratio | Weight | |
| A | Net Sales/Total Assets (simple measure of capital turnover using annual sales) | 1.0 |
| B | Earnings Before Interest and Taxes (EBIT)/TotalAssets (referred to as return on capital employed, this ratio incorporates all capital employed, both debt and equity) | 3.3 |
| C | Working Capital/Total Assets (the difference between current assets and current liabilities divided by the total book value) | 1.2 |
| D | Retained Earnings/Total Assets (this ratio is lower for younger companies since retained earnings accrue over the lifetime of a company; this penalty for youth reflects the higher probability of failure among younger companies) | 1.4 |
| E | Market Value of Equity/Total Liabilities (stock market capitalization for all classes of stock is used in this ratio) | .6 |
Each ratio is then multiplied by its weighting factor and summed to calculate Z:
Z = (1.0)A + (3.3)B + (1.2)C + (1.4)D + (.6)E
Scores below 1.81 indicate a high likelihood of bankruptcy. Scores above 3.00 indicate a low likelihood of failure. Scores in the middle of this range are not clear indicators, but they are less likely to be associated with failure than low scores.
Repeat the analysis periodically and plot Z scores for companies of interest on a graph with Z scores on the vertical axis and time on the horizontal. Significant downward trends in Z scores signal a potential problem, and even if the Z score does not fall below 1.81 the source of the problem should be identified and evaluated. Look at trends within the component ratios to see why the Z score is falling and decide whether it represents a serious problem.
For Privately Held Companies
If you want to analyze a company that is not publicly traded, you will not be able to compute ratio E for the Z score formula. Many companies use smaller suppliers and sell to smaller customers that are privately held. Although Altman did not extend his study to these companies, the other 4 ratios can be computed from D&B reports and a partial Z computed by dropping E. The resulting measure will tend to be lower than the standard Z score. It is best used as a long-term tracking device, with significant declines considered a flag requiring closer scrutiny.
Interested in a Z-Score analysis for your company, customer base, public or privately held competitors, or potential acquisition target? We can conduct an analysis, allowing you to make informed decisions for a reasonable flat rate. Please give me a call at 630.778.7646 or email me at jlafferty@cfo-pro.comto discuss.
The Wisdom of Henry Hazlitt (1894 – 1993)
It is exports that pay for imports, and vice versa. The greater exports we have, the greater imports we must have, if we ever expect to get paid. Without imports we can have no exports, for foreigners will have no funds with which to buy our goods.
The clearing house for these transactions is known as foreign exchange where, in America, the dollar debts of foreigners are cancelled against their dollar credits. In England, the pound sterling debts of foreigners are cancelled against their sterling credits.
This mechanism does not differ essentially from what happens in domestic trade. Each of us must also sell something, even if for most of us it is our own services rather than goods, in order to get the purchasing power to buy. Domestic trade is also conducted in the main by crossing off checks and other claims against each other through clearing houses.
Among the arguments put forward in favor of huge foreign lending one fallacy is always sure to occupy a prominent place. It runs like this. Even if half (or all) the loans we make to foreign countries turn sour and are not repaid, this nation will still be better off for having made them, because they will give an enormous impetus to our exports.
It should be immediately obvious that if the loans we make to foreign countries to enable them to buy our goods are not repaid, then we are giving the goods away. A nation cannot grow rich by giving goods away. It can only make itself poorer. No one doubts this proposition when it is applied privately.
If this proposition is so simple when applied to a private company, why do apparently intelligent people get confused about it when applied to a nation? The reason is that the transaction must then be traced mentally through a few more stages. One group may indeed make gains—while the rest of us take the losses.
The U.S. government has been engaged for years in a “foreign economic aid” program the greater part of which has consisted in outright government-to-government gifts of many billions of dollars. What conceals the truth from many supporters of the program is that what is directly given away is not the exports themselves but the money with which to buy them. It is possible, therefore, for individual exporters to profit on net balance from the national loss—if their individual profit from the exports is greater than their share of taxes to pay for the program.
The real gain of foreign trade to any country lies not in its exports but in its imports. Its consumers are either able to get from abroad commodities at a lower price than they could obtain them for at home, or commodities that they could not get from domestic producers at all. Outstanding examples in the U.S. are coffee and tea. Collectively considered, the real reason a country needs exports is to pay for its imports.
— Paraphrased From Economics in One Lesson (1946)
The Importance of Pricing Business Services Profitably
Some businesses operate under the assumption that Cash Flow will solve most problems. The thought process continues that if the business generates enough volume, profitability will eventually take care of itself. The end of the free flowing credit markets has challenged that belief. Lack of profitability creates a cycle that will eventually destruct and ultimately dissolve the business.
A competent pricing model will include:
A thoughtful competitive analysis: Really understand your competition. What are their expenses? Overhead? Business Philosophy? Are they profitable? Do they have a sound business model? Will they still be a competitor to you in 5 years? Don’t assume that if their prices are lower, that they are doing something right. They may very well be giving the business away and there’s no need to match pricing under that circumstance. Understand your value and use this information to your competitive selling advantage.
Understand Your Value: The value of the business service is based largely on market perception. What value does the market place on your service? Business purchasers and consumers are very educated now on costs and the value of products and services. You will have to make a strong case for your pricing model and understand what they value to procure the prices that you want.
Know Your Costs: The U.S. Small Business Administration advises that the cost of producing any service includes materials, direct labor (direct and supervisory) and overhead. Overhead costs include all other salaries and wages incurred to run the business, plus rent, utilities, office supplies, insurance, depreciation, advertising, etc. The SBA states a reasonable amount of these overhead costs should be billed to each service performed—whether in an hourly rate or a percentage. You need to charge rates that cover current costs (not last year), including wage increases and inflation.
Determining Your Pricing: In today’s economic environment you will find fall out of competitors. Those that were operating on the assumption that volume will take care of profitability are trying to survive and are no longer formidable competitors. This is a perfect time to assess your business’ profitability and pricing model. It’s also time to re-evaluate. What has worked in the past may not work in this environment.
Three common methods of pricing are hourly rates, flat fees, and variable pricing, where negotiating helps set the price for each customer.
If your pricing model has not been profitable for each transaction in the past, now is the time to evaluate it. CFO-Pro can conduct an analysis of your current model, assess the costs you are allocating to each transaction, determine if there are areas to increase efficiencies and create a model that will help your business compete and win in today’s market. Contact us at 630-269-7646 or email me at jlafferty@cfo-pro.com to learn how to build a sustainable, profitable pricing model.
How the Fed Affects the Value of Acquisitions and Equity
Decisions made at the Federal Reserve can profoundly affect the equity of your business. If you are considering a loan to purchase a company or property, or to refinance your existing business, be sure you understand how the debt to equity mix affects your company’s return on equity.
When the Federal Reserve determines that money should be cheap and plentiful it lowers interest rates and increases the money supply, which has an enormous effect on the value of companies that are coveted acquisition targets. This action by the Fed encourages intense competition for good acquisitions and makes it possible for buyers to structure deals based on higher multiples of EBITDA (earnings before interest, taxes, depreciation and amortization) than otherwise would have been possible.
Private equity firms have a lot of capital that needs to be invested, and they prefer making highly leveraged transactions to maximize return on investment in the shortest time possible. The ability to do this depends on the availability of cheap debt, especially senior debt (which is most appealing at a lower interest rate since it gets paid off first in the event of a liquidation).
Prior to the financial crisis, Fed policy made senior debt widely available and inexpensive. Banks were keen to lend 5x+ of EBITDA as part of a private equity deal. The senior debt could be combined with junior debt so that 80% of a deal’s financing would come from debt. This led to a temporary madness in hot industries, driving multiples of EBITDA to near double-digits.”
When the financial crisis unfolded, the risk of deals became an acute consideration. Although the Fed kept interest rates low and the money spigot open, banks became much more cautious. In leveraged deals they now put up, say 2x of EBITDA, instead of 5x+, and cap the total amount of debt allowed. Recently banks have eased up a bit but remain very, very cautious. This amounts to the “old” norm and cannot be considered an aberration. It is unlikely we will see monster multiples again.
So what does this mean if you are acquisition-minded? When leverage decreases, more equity is required to do a deal. When you buy a company using 80% debt the value of your equity investment increases much faster than it does when you use mainly equity. Assume you are acquiring a business for $5 million using 80% debt, or $4 million in debt and $1 million of equity. The value of your equity will increase about 8.5x when the business doubles in size (assuming the multiple does not change). In comparison, if you used 100% equity your equity value would only increase about 2.5x when sales doubled.
| Leveraged | Equity | Growth | Equity | |
| Sales | 5,000,000 | 10,000,000 | ||
| Gross Margin (50%) | 2,500,000 | 5,000,000 | ||
| Overhead | 1,500,000 | 1,500,000 | ||
| EBITDA | 1,000,000 | 3,500,000 | ||
| Multiple | 5 | 5 | ||
| Purchase Price | 5,000,000 | 1,000,000 | 17,500,000 | 5,000,000 |
| Increase in Value | 12,500,000 | 12,000,000 | ||
| Less: debt | 4,000,000 | -0- | ||
| Increase in equity value | 8,500,000 | 12,500,000 | ||
| Growth in equity | 8.5x | 2.5x |
CFO-Pro can help you create the best leverage mix for your business acquisitions.
The Wisdom of Henry Hazlitt (1894 – 1993)
In the history of mankind the essence of economic progress has consisted of getting more production with the same amount of labor. This is the reason that humans began putting burdens on the backs of animals instead of on their own backs, and the reason that thousands of labor-saving devices have, and continue to be, developed.
Translated into national terms, this principle means that our real objective is to maximize production. In doing this, full employment becomes a necessary by-product, although production is the end and employment merely the means. We cannot continuously have the fullest production without full employment but we can very easily have full employment without full production. Nothing is easier to achieve than full employment once it is divorced from the goal of full production. Hitler provided full employment with a huge armament program. Prisons and chain gangs have full employment.
Our legislators do not present Full Production bills in Congress, but Full Employment bills. Wages and employment are discussed as if they had no relation to productivity and output. The conclusion is drawn that a 30-hour week will provide more jobs and will therefore be preferable to a 40-hour week. A hundred confusing make-work practices of labor unions are tolerated.
It would be far better to have maximum production with part of the population supported in idleness by undisguised relief than to provide “full employment” by so many forms of disguised make-work that production is disorganized. The progress of civilization has meant the reduction of employment, not its increase. We have been able to virtually eliminate child labor (in the US), and to remove the necessity of work for many of the aged.
We can clarify our thinking if we put our chief emphasis where it belongs — on policies that will maximize production.
— Paraphrased From Economics in One Lesson (1946
How Much Can You Spend on Marketing?
Many business owners rely on guesswork or product enticement to determine the amount of money to be spent on marketing to increase sales. This is a risky strategy as it doesn’t provide a hard cost calculation method. Following is a straightforward formula to help you understand where your marketing dollars are coming from.
One way to determine how much should a company spend on marketing is to develop a “Unit Cost” model. You can apply this model formula to virtually any medium. Use the following steps to determine your allowable marketing costs.
- Start with the average value of your sale. To simplify, in our example your product or service sells for $1,000.
- Calculate every conceivable direct cost (fixed and variable) such as the cost of goods, fulfillment, premiums, order processing, etc. (Do not include overhead or marketing costs here.) Assume these costs add up to $500.
- Next, include overhead (rent, salaries, office expenses, telecommunications, etc.) as a cost. For our scenario let’s assume these costs add up to $100.
- Now, establish a profit objective. For example, you might set your profit objective at 20% of sales minus direct costs and overhead, or $80 per order ($1,000 – $500 – $100 = $400 x 20% = $80)
- You can now calculate your allowable marketing cost by subtracting the direct costs, overhead, and profit objective, from the average sale price. In this example, it amounts to $320 ($1,000 – $500 – $100 – $80)
- Now you can calculate your allowable marketing expenses on a cost per thousand (CPM) basis. Use the CPM of the medium you are employing. Assume that you have a cost of $4,000 per thousand delivered ($4.00 each), inclusive of creative costs, printing, inserting, mailing list rental, and postage.
- Finally, calculate the response rate required to support these numbers. When you divide the marketing CPM ($4,000) by the allowable marketing cost ($320), you learn you must generate 12.5 orders per thousand — a response rate of 1.25% — to meet the profit objective of 20% (or $80 per order).
A response rate of 1.25% means everyone gets paid and your profit objective is reached.
Keep in mind that if you wanted to increase the allowable marketing cost by say 5%, the required response rate must also move up 5%, to 1.3125%. The crucial question then is: can you increase your response rate more than enough to pay for the added cost?
Recapture the Profit You Are Currently Giving Your Creditors
Why would anyone want to own a leasing company? (Why does GE Capital Credit exist?)
A leasing company earns the difference (or spread) between rental income / residuals and the cost of funds. Problems do exist for leasing companies:
- Potential bad credit
- Potential inadequate residuals
- Potential lack of customers
- Potential lack of access to funds
- Potential expensive cost of funds
- Overhead / personnel to handle the complex administration duties
Why do the leasing companies keep leasing? The answer is simple: They make a lot of money.
What if you owned your own leasing company and rented only to yourself? This is called a “captive leasing company”. You could keep the profit currently made by the GE Capital Credit, et al, on your money, without the potential problems they face. This is what R. Nelson Nash talks about in his book, Becoming Your Own Banker (see my Issue #11, May 2009) Nash’s “Infinite Banking Concept” tells you how you can retain the profit currently being made by banks and finance companies from the money you currently pay them. Additionally, structured properly, your captive leasing company can offer some tax savings as well as lawsuit protection.
Covenant Leasing Services, Inc. (www.covenantls.com) of Elmhurst, Illinois, can help you structure your catpive leasing company properly as well as handle all the administrative responsibilities so you as the owner only have to pick out the corporate name, fund the company, and select your equipment. Every transaction, including incorporation, is handled by CLS, a total “turn-key” operation.
When is it right for you to consider setting up your captive leasing company? Covenant Leasing Services, Inc says it make economic sense if you average adding / replacing $40,000 per year of capital equipment.
Don’t miss out on the opportunity to recapture the profit you are currently giving to someone else. Consider your own captive leasing company; call Covenant Leasing Services, Inc at (866) 964-4727. Or call me at 630-778-7646 and I will get you introduced to CLS.
The Wisdom of Henry Hazlitt (1894 – 1993)
A common and long standing economic delusion is that machines create unemployment. This fallacy is often the basis of labor union practices and propaganda, as reflected in hundreds of make-work rules and featherbed practices that perpetuate confusion in the public mind.
Every day each of us is engaged in trying to reduce the effort required to accomplish a given result. Every employer is continuously seeking to achieve results more economically and efficiently — that is, by saving labor.
A manufacturer who buys a machine that can produce a product for half as much labor now has more profits than before. It is precisely out of these extra profits that subsequent social gains are made. The manufacturer will use these extra profits in at least one (if not all) of three ways: (1) Expand operations by buying more machines to make more product, (2) invest in some other industry, or (3) increase his own consumption. Whichever course(s) is taken, employment is increased, whether directly or indirectly.
The reach of benefits continues: Decreased costs of production will begin to drive down product pricing, in turn passing savings along to consumers. Consumers will have money left over to spend on other products and services, and so provide increased employment in other lines.
What machines do is to bring an increase in production and an increase in the standard of living by making goods cheaper for consumers, or by increasing wages because they increase the productivity of the workers.
— Paraphrased From Economics in One Lesson (1946
How to Accelerate Your Wealth Creation — Become Your Own Bank
The average American is paying from $0.54 to $0.64 of every dollar they earn on interest and taxes (using an average of $0.24 – $0.34 for interest on your loans for home, car, credit cards, etc, and $0.30 for taxes). That equals 54% to 64% of your total income!
Realizing how much money the typical American is paying out in interest begs the question: Why Not Become Your Own Bank?
It’s not as difficult as it sounds…. There exists today a vehicle that’s been around a long time (it’s not a gimmick) that allows you to create wealth by recapturing the interest that you’re currently paying to others. Following is a synopsis that will help you get started. I invite you to contact me with questions or comments.
Understand the Concepts (adapted from the Infinite Banking Concept by R. Nelson Nash at www.infinitebanking.org)
The first basic concept that must be understood is that financing is a process, not a product. Financing involves both the creation and maintenance of a pool of money and its uses.
The second basic concept to increasing your wealth is to understand the power of your cash flow. Everything we buy involves financing. We either pay interest to a lender, or we pay cash and give up interest we could have otherwise earned (also known as “lost opportunity cost”).
Therefore, the founding principle of becoming your own bank is that anytime you can cut the payment of interest to others and direct that same market rate of interest to an entity you own and control, and which is subject to minimal taxation, you will significantly improve your wealth generating potential.
Apply the Concepts: Cash Flow Effect of Using an Automobile (illustrative rates and assumptions from IBC by Nash; you can use any numbers here and it would work just as well)
There are five methods of having the use of an auto over the lifetime of a person. Assume your car is replaced every 4 years at a cost of $10,550, financed at 8.5% interest for 48 months, for a total timeframe of 44 years.
- Lease each year for 44 years. At the end of each 4-year period you have no equity to show for the expenditure. Over 44 years you will have paid approximately $175,000 for your cars.
- Finance with a bank. Every 4 years you have a car to trade in. Over 44 years you will have laid out $137,280 ($260 per month for 528 months). Your equity will be a used car.
- Pay cash for a new car every 4 years. Over 44 years this cost amounts to $116,050 ($10,550 for 11 new cars over 44 years). You have to defer the use of the first car for 4 years by saving the money for 4 years and immediately start accumulating money again in the same savings account to prepare for the next purchase. Your equity is a used car and the savings account.
- Create a pool of money before using it for the car purchases. Accumulate funds in a savings account monthly over a 7-year period at a rate of $5,000 annually. At the end of each year buy a CD (at someone else’s bank) for $5,000 at a yield of 5.5%. At the end of 7 years you have $41,071 (after tax). You can now start self-financing your car purchases by withdrawing $10,550 from the CD. Continue to fund the savings account monthly ($252.50) and annually withdraw $3,030 from it to buy a new CD each year. After 44 years you will have cash remaining of $187,229 in CDs. Remember: you are using someone else’s bank and so the bank’s dividends are going to the bank’s stockholders. You are earning only the interest that the bank pays you.
- Use dividend-paying life insurance as a depositary of the necessary capital to create the banking system to finance your autos. Put the same $5,000 savings per year into life insurance; after 7 years of capitalization, you withdraw dividends in the amount required to pay cash for the car. Make the annual premium payments of $3,030 to the insurance policies instead of paying a bank / finance company. After 44 years you will have cash remaining of $551,593 in the policies. Remember: in the life insurance method the policy owner (you) is earning both interest and dividends. There are no outside stockholders; you are the owner and you make all the decisions.
You now know the essence of the Infinite Banking System — recovering the interest that one normally pays to some lender and then lending it to others (yourself) so that the policy owner makes what a banking institution does.
The real power of the life insurance method is shown in a comparison of the retirement income that can be realized from each method. Assuming a withdrawal of $50,000 per year from each, the CD account (#4 above) is soon out of money, but the life insurance policy (#5) is still growing and the net death benefit for a beneficiary will exceed $1,000,000!
Economics of Becoming Your Own Bank
There are no free lunches when it comes to the cost of starting a business — unless someone gives you the starting capital. That is why you have to create the initial pool of money above. In order to issue a CD, a banker has to create a bank. From the start of the idea until it is break-even, it will take the banker a few years to achieve. The same principle applies to life insurance. Each new life policy is a new business. There is a start-up cost in creating a new business. It takes a life company about 13 years to amortize the “cost of acquisition” of a new policy.
The difference between the cash remaining in Methods 4 and 5 above is $364,364 ($551,593 – $187,229). You have just isolated the amount that went to the banker, compounded over the term (44 years) of the investment! There really is no justifiable comparison between the methods.
Become Your Own Bank Now…
Using Key Financial Indicators Effectively
A financial ratio has no single correct value. It depends on one’s perspective and the competitive strategy employed. Lenders like a high Current Ratio that suggests strong liquidity and high likelihood of repayment. From an operating viewpoint, the important question is not whether the current ratio is too high, but whether the chosen strategy is best for the company.
How do you interpret ratios and other key financial indicators? How do you decide whether a company is healthy or sick? One way is to compare a company’s ratios to industry ratios (you can look up this information in RMA studies at your local library) to see how a company measures up to its peers. Keep in mind, though, that company-specific differences can result in entirely justifiable deviations from industry norms.
The most useful way to evaluate ratios and indicators involves trend analysis (monthly), noting how the ratios change over time. Ratios that show a negative trend mean that less cash is coming in. Here are my most used and recommended ratios:
| Indicator | Focus |
| Gross Profit Margin % | Gross Profit / Sales• This is your most crucial ratio as it measures the % of each sales dollar available for covering overhead and producing bottom-line profits |
| Monthly Overhead $ | Expected Monthly Overhead Average for Current Year• This number (accumulated on your monthly P&L) will highlight any “creep” or outright jump; allowing you find the cause and take timely action |
| Interest Coverage Ratio | EBITDA (earnings before interest, taxes, depreciation & amortization) / Interest Expense• This measures how easily you can repay your borrowings. In good times this ratio should be at least 1.25; in bad times, only the banker knows |
| Current Ratio | Total Current Assets / Total Current Liabilities• This measures the ease with which you can pay bills as they come due. Ratios greater than 1 : 1 are easier to manage than 1 : 1 or less (e.g., .75 : 1) |
| Quick Ratio | (Cash & Accounts Receivable) / Total Current LiabilitiesThis ratio is a good measure of a company’s short-term cash position. A ratio of less than 1:1 means you’ll have to decide who gets paid when the next dollar comes in. A worsening condition (i.e., a number lower than 1 in the first postion) means your sales aren’t keeping up with your bills |
| Days’ Sales in AR | (Accounts Receivable / Sales) x 365• This number indicates the days, on average, your customers take to pay you. 45 and under is good; 60 and above is bad. If this number rises it means you have less cash coming in and may have to borrow money to pay bills |
| Days’ Sales in AP | (Accounts Payable / Sales) x 365• This is the number of days, on average, you take to pay your suppliers. The closer this number is to the AR number, the easier it will be on cash flow. Generally, you should pay your suppliers as close to “terms” as possible to maintain good relationships, and focus on tightening your AR collections times |
| Days’ Sales in Inventory | (Inventory / Sales) x 365• This indicator measures the amount of time to convert inventory into sales. This is another crucial number because you have to create a sale—and then collect that sale. Bottom line: if this number is higher than the industry median, be sure there’s a valid reason |
| Debt to Equity Ratio | Total Liabilities / Total Equity• You should pay close attention to this ratio. In tough credit markets you want bankers to see you as a good candidate so manage this ratio by putting more equity into the business or by converting your loans to equity. A higher ratio will force you to focus intently on cash flow and paying down debt—to the exclusion of business-building activities. What is a good ratio? Only the banker knows |