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Financial advice from a business veteran.

In these difficult economic times, CPAs should take a more active role in guiding a company's financial affairs-especially in capital management. So says John R. Meinert, chairman emeritus of Hartmarx Corp. and Hart Schaffner & Marx. He also draws on over 20 years' experience as chief financial officer. Since retiring last year from Hartmarx, he has launched a new career as a principal in the J.H. Chapman Group, Ltd., an investment banking firm in Rosemont, Illinois. A WIDER ROLE FOR CPAs Some CPAs see their role in capital management as minimal. Too many limit their job to gathering and reporting historical data-accounting for what happened, not laying out the design for what will happen.

That's unfortunate. CPAs have a unique skill that they can and should bring to bear on financial matters.

At the very least, CPAs should apply their analytical skills and play the devil's advocate, questioning the source of corporate forecasts, ferreting out false premises and observing when emotions are overwhelming better judgment.

To be sure, that's a difficult role to play. But it's worth the candle: It can enhance a business's fortunes and the accountant's professional status. In this way CPAs can add respect for their financial acumen and business judgment and gain more decision making responsibility.

One area in which they can apply their skills is the management of capital. Here is some useful guidance. CORPORATE DEBT STRATEGY GONE BAD Debt has been getting a lot of bad press lately. That's because some companies have been borrowing excessively when they should have been building equity. Now they're paying the price for those errors.

Other, more conservative businesses are being hurt by the spate of negative publicity: Overly cautious lenders deny credit even when it would be used for the right reasons and structured in the right way. In effect, these lenders have been demanding that borrowers demonstrate both a good cash flow and a strong asset base; that's like wearing both a belt and suspenders.

Corporate America's rush to debt was understandable, though imprudent. After all, the least expensive way to raise capital-after accounting for taxes-is with debt. This was a major incentive behind junk bonds.

To better appreciate the lure of corporate debt, assume the following: A debt-free company is in the 40% tax bracket, generating a 12% return on equity. Assume, too, that 80% of its equity is replaced with debt at an interest rate of 15% (9% after taxes). That company's return on equity doubles to 24%! If the company could borrow at 12%, or 7.2% after taxes, the return on equity would climb to 31.2%. Earnings before interest and taxes (EBIT) are unchanged, so all the gain in both examples is from tax savings, which effectively lowered the cost of capital on the 80% debt segment. By using such financing to dictate their actions, many businesses pushed their debt leverage to extremes, even to the point of ending up with negative book values.

What many executives failed to appreciate is that growth at any cost may be too expensive. When debt exceeds a business's ability to carry it, or when related interest consumes the earnings, management probably has exercised poor business judgment. Management's goal should be increasing profit for shareholders, and the only way debt can make financial sense is when its cost, after tax, is lower than the resulting return on equity. BUY-BACK OR EXPANSION Some publicly held companies with low stock values-say, below book value-buy back their stock to increase per-share earnings and book value with debt that costs them, after taxes, less than their return on equity. While such buy-backs may be attractive investments, management can be faulted for not finding attractive expansion opportunities instead.

Until recently, the risk of growth via debt was concealed by fast appreciation of assets, swelled by inflation and speculation. Some managements, so used to optimistic earnings, did not quickly grasp the impending impact of economic slowdown and tight credit. As a result, they allowed their companies to get mired in debt.

These managers may blame external factors as the sole reason for their debt troubles, but the causes run deeper and include excessive optimism and failure to maximize longterm return on investment. A prime example is carrying huge, slow-turning inventories and hoping for sales growth-a disastrous, unprofitable use of debt. FINANCIAL STRATEGIES At the turn of the century, financial people considered the balance sheet the key statement of a business's condition; back then, the statement of earnings was not always reported. High net worth and low debt were hallmarks of a powerful and prosperous company.

Today, the emphasis is on cash flow. While earning power is the key indicator, smart financial managers are once again balancing the advantages of debt and equity. The costs of righting the balance can be high, in terms of financial and human costs. The rebalancing may be an act of corporate survival, and it depends on belt-tightening and downsizing, although management would rather use the word lightsizing" to describe its corrective actions. Rightsizing involves retrenchment to the point where a business's cash flow is brought in line with its debt-payment demands. TAILORING DEBT Many companies suffer from inadequate financial planning, with small and mid-size businesses affected most frequently. Their usual error is to put most of their debt in one basket. Usually that basket is some form of bank borrowing. Financially well run companies segment their capitalization and borrowing into distinct categories. They are n Equity. This is the staying power of a business. It's the cushion for the lean years when downturns leave the business cash short. Equity can be raised by issuing stock, for activities such as acquisitions, employee and executive stock option plans and convertible debt. As its equity builds, a company's capacity to add long-term debt grows apace. The conservative recommended ratio of equity to long-term debt is two to one. * Long-term debt. If a privately held company is large enough, it can float public bonds as well as make private placements. Smaller companies could turn to insurance companies for long-term money or a mortgage loan, or they could turn to commercial lenders or banks for a secured or asset-based loan. The key is to design the debt-in size and duration-to match the business's needs and cash flow. That takes realistic forecasting and fiscal self-control. Long-term borrowing is especially attractive because interest rates usually are lower than short-term bank loans. Also, long-teryn planning is easier and payments can be better matched to cash flow. * Seasonal debt. This is the borrowing that's needed to carry a company through a fiscal cycle. When its products are delivered and receivables collected at the end of its natural fiscal year, seasonal loans should be paid in full. If management has to carry that debt over for lack of funds, even when fast growth rather than slow sales causes inventory accumulation, that's a signal of poor financial forecasting.

Unfortunately, banks too often don't see that red flag or simply acquiesce by rolling the debt over, hoping it's temporary.

Both the bank and the business lose when a short-term, seasonal loan is carried over. If allowed to build debt, the business can be overwhelmed by its financial obligations and find itself unable to meet pay-back demands and to get additional credit. BORROWING ADVICE Before knocking on a bankees door, a financial officer- should ask: What kind of borrower is my company? Is our business plan impressive? Are the funds going to be put to the best possible use? What kind of security would a lender demand?

If it's an asset-based borrower, a small company must look at its tangible assets and find the best way to borrow on them. If the company is unable to attract bankers willing to extend working capital loans, it may have to factor receivables, work with vendors to finance inventory or mortgage the fixed assets. Even customers may be a source of funds, either by making advance payments against orders or by covering the cost of materials to be used for production.

If the business is a service company with few tangible assets but with good cash flow, it still may be able to borrow on that cash flow. However, if a business has neither cash flow nor assets, it's in real trouble. Such a company often wisely seeks to be acquired or to develop a joint-venture relationship with another business in order to meet its capital needs.

Financial officers should realize banks like to negotiate loans that the company can repay out of cash flow. If the borrower is a successful and growing company, more funds will be needed and the loan will not self-liquidate; in fact, permanent capital will be needed.

Yet many borrowers make the misstake of trying to squeeze longerterm loans out of bankers rather than use other means; such efforts don't enhance a banker's view of the company's financial management.

Sometimes a bank will agree to extend a loan a bit, but only with the understanding that the business will use the extra time to secure more permanent capital through equity or long-term debt.

It's risky to oversell the bank when presenting cash-flow projections and pay-back plans. If the bank naively accepts those unattainable projections, it may then set default positions on those estimates. The price of not meeting those projections can be quite high-default and possible bankruptcy.

The best way to negotiate with a bank is to present realistic figures, while making it clear that the projections are conservative and there is a good chance the company will exceed them. Make no promises. Bankers are more likely to believe such a presentation and set a realistic pay-back schedule. 2
COPYRIGHT 1991 American Institute of CPA's
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Copyright 1991, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Meinert, John R.
Publication:Journal of Accountancy
Date:Jun 1, 1991
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