How Much Is Enough?

Author:Hank Harris
Publish Date: Mar 22, 2022 04:54 PM EDT

Female hands picking fresh tomatoes to wooden crate with vegetables main

Life is good. I have my own business, and it affords me a nice lifestyle, nice home, cars, vacations, clubs, and great schools for the kids. Living the dream, and yes, business is good.

Or is it? How good should business be – or how much is enough? While every business is unique, there are common ways to think about this question. When you buy a car, it comes with a built-in set of instruments, dials, and gauges (all increasingly electronic). These help you run the car successfully and navigate to your desired destination. When you organically create a business, there is no "built-in" dashboard. Most successful business owners need to create their own.

Since the financial side of the business is the most implicitly measurable, we will focus on that aspect, starting with the question posed above. When your business makes a profit, some of that money will be earmarked for reinvestment in the business. This may take the form of capital expenditures or building working capital on the balance sheet to fund future growth. Some money will go toward employee bonuses, owner distributions, and new hires. And of course, some to taxes.

The first place to start contemplating what your bottom line should look like (before taxes) is the basic risk vs. rate of return question applicable to all businesses. How risky is your business? Assuming our focus here is on private enterprise, the risk is perceived to be higher than the public stock market. There are many ways to assess private business risk, but the key point here is that return requirements are relatively high. If a diversified public investment portfolio can yield 10%, a private investment probably warrants 20%. (The return demands I dealt with over my career were well north of that). What you have at risk is the net worth of your business. To use a simple example, let's say your business is worth one million dollars, and a risk assessment suggests a minimum return on investment is 30%, your target bottom line should be at least $300,000.

Your capital in the business has a cost associated with it. The "Weighted Cost of Capital" is a formula that calculates your cost of debt blended with what your equity would return if it was invested in a business similar to yours. This number is typically lower than your target return set above, but it sets a "floor" on the minimum amount of money you must make to be economically rational. In other words, when your earnings are lower than this number, you are destroying economic value and not in a sustainable long-term scenario.

Your returns are a function of your P&L statement (earnings) and your balance sheet (investment). So, how your balance sheet is structured is important. Industry-specific benchmarks suggest how much working capital should be in your business relative to your revenue. You want your business to be properly capitalized as a private business owner. An undercapitalized business will struggle with cash flow and, at the extreme, even flirt with insolvency. But an overcapitalized business can dilute your returns, keep needless capital at risk, and hinder the owners' investment diversification.

Some benchmarks can assist you in managing other parts of your balance sheet. Balancing how much bank debt to use and balancing short-term and long-term debt are common issues for most companies. How much of your balance sheet can be devoted to fixed assets, how old those assets should be, and the role of depreciation are other areas where industry and company size benchmarks can aid management decision-making.

Most business owners do not get into business because they enjoy finance. Outside CPAs, consultants, internal accountants, and CFOs are all great resources, and owners can delegate to them for support. But, it is best to delegate, not abdicate. Finance is the language of business. Owners should be able to "speak" a certain amount of the language, and they should teach it internally. My experience is that the higher the degree of financial literacy is internally in a business, the better it tends to perform.

So yes, life is good- but how about business? How much is enough? The language of finance has an answer.




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