Who Owns the Business?

October 2004

How Do We Use the Balance Sheet to Make Decisions?

The balance sheet tells us three crucial stories. First, it tells us who owns the business. Second, it tells us how lean and mean the organization is running. And third, it tells us how liquid the organization is. Let’s cover the first story in this newsletter.

The first question the balance sheet answers: Who Owns the Business?

When you first open the doors of your business, you have two places to get money: one you can take out a loan and two, you can sell ownership - or stock - in your business to others or to yourself.

Look at what is included in the liabilities and equity portions of the balance sheet:

Liabilities
*Accounts Receivable
*Long-Term Debt

Equity
*Stock
*Retained Earnings

Remember that these portions of the balance sheet tell us where the organization gets its money (the asset portion tells us what we did with the money we collected -for more on this see last month's newsletter).

On day one you will not have any retained earnings or accounts payable because you have not created or sold anything. So you are left with long-term debt and stock.

When You Have Debt, the Lenders Own the Business

Long-term debt is loans that the business took out either to expand or just plain operate. When you have a loan, in essence, the bank owns your business.

Just as when you have a home mortgage, you don’t really own your house until you pay the bank the final principle payment.

What do banks expect in return for doing business with you? They expect interest. So doing business with banks costs something. They expect to be paid on a regular basis. You cannot skip payments for a few years at your convenience. If you do that, they will call the loan and come take away the stuff you pledged as collateral.

And if you are what they consider a high-risk loan client, they may require you to do all sorts of things in the loan agreement. Clauses of the loan agreement are called ‘loan covenants’. Loan covenants are promises that you make to the bank in return for getting the money. The bank doesn’t ever give you $10 million and say ‘Go have a good time.’ There is always a catch.

I have seen loan covenants that require you to keep a certain amount of cash in the lending bank at all times. Covenants may require you to keep inventory levels at a certain amount or limit debt with other lenders. If you fall outside of their dictated parameters, you have “busted the covenants’ and the bank can call your loan.

If you are super high risk, the loan covenants can require you to replace members of your board of directors with bank officers or require that you report to them on a daily basis the results of your operations.

A girlfriend of mine was a CFO for a company that had filed for bankruptcy. The bank decided to loan them more money in hopes that the money they had already invested in the company would not go to waste. The bank required my girlfriend to submit the three key financial statements, plus a detail on sales prospects and inventory balances every day. The bank also kicked the owners off the board and replaced them with a few business consultants that they believed could turn the company around.

If you take the money, you also take whatever terms the bank dishes out.

When You Have Stock, the Stockholders Own the Business

Now, if you have stockholders, you worry about a different set of issues. Stockholders expect two types of return on their investment. One is to share in the wealth in the form of dividends. A dividend is usually declared on a quarterly or annual basis and is meant to take the profit that the company made and pay it out in cash to the shareholders.

Many companies do not pay dividends. In young, growing companies, the stockholders prefer that instead of paying them dividends, that the company instead take the extra profits and plow them back into the company.

This will give the investor the second type of return that they are looking for – growth of the value of the stock. If the company plows the profits back in and grows in market share or creates exciting new products, the worth of the stock goes up.

The shareholders have a lot of power. They have the right to vote anytime the articles of incorporation of the business are changed. You can liken the articles of incorporation to the United States’ Constitution. The articles spell out how the business is organized, how many folks are on the board of directors, how often they meet, what the mission of the organization is, if they pay dividends and when, how many shares of stock can be issued, etc.

But even more important is the shareholders power to choose the leadership of the corporation. They get to choose who sits on the board of directors. The board of directors chooses the executive management and executive management chooses every other player in the organization. So the shareholders are at the top of the food chain.

It is not uncommon for the shareholders to get together and vote new directors in thus influencing the future of the company. Corporations, then, end up doing things to please their shareholders that may not be beneficial to the internal operations of the company.

I was teaching a Finance for Non-Financial Managers course at a Fortune 500 company a few years ago on the day that the company announced its quarterly results to Wall Street. Unfortunately, the company did not make its projected revenue figures and they expected that their stock price would plummet as a result.

So to prove to Wall Street and the shareholders that they were serious about maintaining profitability, they laid thousands of people off on the same day they announced quarterly results. I was told that the team that had hired me had been eliminated and that I was welcome to finish the day’s training, but they weren’t sure when they would have me back.

This move did indeed stabilize the stock price. It only decreased by pennies; the stockholders loved the move. But internally, the Fortune 500 Company was in turmoil for half-a-year. Morale went down the tubes. So what looked good from the outside, to investors, may not have been the best move internally.

So to summarize, by financing your organization with stock, you may be taking on an obligation to pay dividends on a regular basis AND you give up some control of your business, as shareholders are the top of the food chain.

When You Have Retained Earnings, the Business Owns the Business

When you have retained earnings, the company owns the company. Retained earnings are the earnings or profit that the company made that they hold for themselves and don’t pay out as dividends. Retained earnings is, in general, the best way to finance your company’s operations.

Think of it in personal terms. You do not want to take a loan out from your parents or go into major credit card debt to finance your life. We can equate that to long-term debt. You also do not want to sell parts of your body (or your soul to the devil J) to finance operations. You can very loosely equate that to stock or “equity” financing.

You prefer to make your own money and pay your own way. In this way, you are not beholden to anyone. This can be equated to retained earnings.