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Using the Z Score to Manage Corporate Financial Health

We use Altman’s Z Score as our measurement tool to assess a company’s financial condition. It incorporates fundamental financial analysis, offers a consistent measurement methodology across all business segments, and an enhanced level of transparency by use of fully disclosed and open calculation model.

Z Score Advantages

The Z Score provides a quantitative measurement into a company’s financial health. The Z Score highlights factors contributing to a company’s financial health and uncovers emerging trends that indicate improvements or deterioration in financial condition.

The Z Score is a critical tool business managers use to assess financial health. It helps managers align business strategies with capital allocation decisions and provide transparency of financial condition to lenders and equity capital providers. Business managers use the Z Score to raise capital and secure credit. The Z Score is an effective tool to demonstrate credit worthiness to bankers and soundness of business model to investors.

The Z Score is based on actual financial information derived from the operating performance of the business enterprise. It avoids biases of subjective assessments, conflicts of interest, brand and large company bias. The Z Score employs no theoretical assumptions or market inputs external to the company’s financial statements. This provides users of the Z Score with a consistent view and understanding of a company’s true financial health.

Background

The Z Score was first developed by NYU Professor Edward Altman. The Z Score methodology was developed to provide a more effective financial assessment tool for credit risk analysts and lenders. It is employed by credit professionals to mitigate risk in debt portfolios and by lenders to extend loans. It is widely utilized because it uses multiple variables to measure the financial health and credit worthiness of a borrower. The Z Score is an open system. This allows users of the Z Score to understand the variables employed in the algorithm. All the mysteries and added cost of “proprietary black box” systems are avoided empowering users to enjoy the benefits of a proven credit decision tool based solely on solid financial analysis.

The Z Score is also an effective tool to analyze the financial health and credit worthiness of private companies. It has gained wide acceptance from auditors, management accountants, courts, and database systems used for loan evaluation. The formula’s approach has been used in a variety of contexts and countries. Forty years of public scrutiny speaks highly of its validity.

Z Score Formula

The Z Score method examines liquidity, profitability, reinvested earnings and leverage which are integrated into a single composite score. It can be used with past, current or projected data as it requires no external inputs such as GDP or Market Price.

The Z Score uses a series of data points from a company’s balance sheet. It uses the data points to create and score ratios. These ratios are weighted and aggregated to compile a Z Score.

Z Score = 3.25 + 6.56(X1) + 3.26(X2) + 6.72(X3) + 1.05(X4) where

X1 = Working Capital / Total Assets
X2 = Retained Earnings / Total Assets
X3 = Earnings Before Interest & Tax / Total Assets
X4 = Total Book Equity /Total Liabilities

If you divide 1 by X4 then add 1 the result is the company’s total leverage.

The higher the score the more financially sound the company.

Z Score Ratings cutoff scores used in classifications:

AAA     8.15             AA        7.30

A          6.65              BBB     5.85

BB        4.95             B            4.15

CCC     3.20             D           3.19

Credit Worthiness and Cost Of Capital

Lenders and credit analysts use Z Scores because they are effective indicators and predictors of loan defaults. it is an important risk mitigation tool and helps them to better price credit products based on borrowers credit worthiness.

Utilizing a 10 year corporate mortality table demonstrates how Z Score ratings correlate to defaults. Those with a rating of A or better have a 10 year failure rate that ranges from .03% to .082%. The failure rate for those with a BBB rating jumps to 9.63%. BB, B and CCC failure rates are 19.69%, 37.26% and 58.63% respectively. These tables will differ slightly as each producer uses different criteria but overall they are quite similar.

Borrowers with higher Z Scores ratings will have a better chance of obtaining financing and secure a lower cost of capital and preferred interest rates because lenders will have greater confidence in being paid back their principal and interest. Financial wellness is an indication of strong company management and that effective governance controls are in place.

Managing Business Decisions to Improve Financial Health

The Z Score is also a critical business tool managers utilize to make informed business decisions to improve the financial health of the business. The Z Score helps managers assess the factors contributing to poor financial health. Z Score factors that contribute to under-performance; working capital, earnings retention, profitability and leverage can be isolated. This enables managers to initiate actions to improve the score of these factors contributing to financial distress. Targeting actions to specific under-performing stress factors allows managers to make capital allocation decisions that mitigate principal risk factors and produce optimal returns.

Focus areas for managers to improve Z Score are transactions that effect earnings/(losses), capital expenditures, equity and debt transactions.

The most common transactions include:

  1. Earnings (Net Earnings) increases working capital and equity.
  2. Adjust EBIT by adding back interest expense.
  3. Adjust EBIT by adding back income tax expense.
  4. Depreciation and amortization expense is already included in the earnings number so it won’t have an additional effect on earnings or equity but it will increase working capital as noncash items previously deducted.
  5. Capital Expenditures (fixed asset purchases) decrease working capital as cash is used to pay for them (whether the source is existing cash or new cash acquired from debt).
  6. Short term debt transactions have no effect on working capital as there are offsetting changes in both current assets and liabilities but does change total liabilities and total assets.
  7. Acquiring new long term debt increases working capital, total liabilities and total assets.
  8. Typical equity transactions (other than earnings, which we have already accounted for) are dividends paid to stockholders resulting in decreases to working capital and equity.
  9. New contributed capital increases working capital and equity.

Scenario Analysis

Using the Z Score financial managers can actively manage their balance sheet by considering transactions and initiatives designed to impact financial wellness. Considerable attention needs to be placed on how losses, sale of fixed assets and long term debt payments effect financial condition.

In the above we included the basic transactions that would likely occur but you can do the same for any scenario by applying the same concept. It may take a little practice to think in these groupings but you’ll shortly find yourself with the ability to project any event. The effects can be measured and revised as necessary by adjusting the contemplated transactions. Remember that several variables exist and that a combination of choices might be necessary to keep your financial strength at the desired level.

Any projection should include the calculation and comparison of key metrics to historical results to ensure that assumptions have been correctly calculated. Significant deviations from prior results should have adequate explanations. Maintaining a strong working capital position can offset the negative effects from increased debt, increased assets and minor earning declines.

Sum2′s Profit|Optimizer

Sum2 publishes the Profit|Optimizer.  The Profit|Optimizer is a risk assessment and opportunity discovery tool for small and mid-sized businesses.  It assists managers to identify and manage risk factors confronting their business. The goal of the Profit|Optimizer is to help business mangers demonstrate creditworthiness to lenders and make make informed capital allocation decisions.

Sum2 boasts a worldwide clientele of small and mid-sized business managers, bankers, CPA’s and risk management consultants that utilize the Profit|Optimizer to help their clients raise capital with effective risk governance.

Cautions

Financial models are not infallible and should be used in conjunction with common sense and with an awareness of market conditions. It is important to understand your model so that other considerations can be incorporated when necessary. Note that most models (Z score included) use a proxy (working capital) for liquidity which works well until there are severe disruptions in credit markets as recently encountered. Use caution with all models. Use extreme caution when using a proprietary black box system where you can’t understand all the components. Are these users aware or ignorant of possible issues?

Trust but verify seems like a prudent policy.

Conclusions

The Z Score is a valuable management tool to proactively assess the financial condition of the company’s balance sheet, uncover factors that are stressing the balance sheet and initiate actions to improve the financial wellness and credit worthiness of the firm. All business decisions and actions are ultimately revealed in the company’s balance sheet. The Z Score measures the effectiveness of business decisions. It empowers managers to anticipate changes occurring in credit worthiness and proactively manage changes in financial condition.

Armed with a tool to calculate future financial positions managers have the latitude to better manage outstanding receivables, improve liquidity and lower their cost of capital. Calls for capital, negotiations for funding or decisions in setting credit policy can now be made from a knowledgeable position with a set of supporting facts.

The Z Score gives business managers an important negotiating tool to defend their credit rating during capital raises when excess leverage or deficient levels of working capital and equity are present.

This post was authored by CreditAides.

This post was edited by Sum2llc

Risk: small business lending, credit risk, commercial lending, SME

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July 22, 2010 Posted by | Uncategorized | , , , , , , , , , , , , , , , | 3 Comments

Small Business Optimism Rising

The National Federation of Independent Business (NFIB) has just released the Small Business Economic Trends Report for May 2010. The report published since 1973 measures small business sentiment on numerous economic and business factors that confront small businesses.

This months report indicates that small business optimism is improving. The NFIB index rose 3.8 points in April.  The rise boosted the optimism Index above the 90 level for the first time in 21 months.  The NFIB Index has never registered  such a protracted  reading of negative sentiment in the four decade history of the index.

During April nine of the ten index components rose, an indication  of  improving conditions of most business factors.  The single exception  was employment sentiment which continued to signal small businesses remain cautious on creating new jobs.  Historically, small businesses have been the major driver in job creation following recessions.  The poor job creation reading by the index  continues to be a  contra indicator of economic recovery. Small business owners are by nature and temperament optimistic and the report indicates that small businesses are still very cautious about allocation capital for jobs to meet improving business conditions.

Highlights of the Report:

  • Jobs:   Average employment per firm was negative 0.18 in April.  Average employment has fallen each month since July 2008.   Eleven percent of survey respondents reported unfilled job openings.   During the next quarter 7 percent plan layoffs and 14 percent plan to create new jobs.
  • Credit: The index reports that 31 percent of regular borrowers  report difficulties in arranging credit.  A net 14 percent reported difficulty in getting loans.  Overall, 91 percent of the owners reported all their credit needs met or they did not need to access credit.  Only 4 percent of the owners reported finance as their top business problem (down 1 point).  Pre-1983, as many as 37 percent cited financing and interest rates as their top problem.
  • Profits: Respondents reported profits improved by 12 points in April.  14 percent reported profits higher (up 5 points), and 51 percent reported profits falling (down 7 points).   Of the owners reporting higher earnings, 57 percent cited stronger sales as the primary cause and 7 percent each credited lower labor costs, material costs and higher selling prices.   For those reporting lower earnings compared to the previous three months, 57 percent cited weaker sales, 4 percent blamed rising labor costs, 6 percent higher materials costs, 2 percent higher insurance costs, and 6 percent blamed lower selling prices.
  • Prices: Fifteen percent of respondents reported raising average selling prices, but 24 percent reported average price reductions.  April is the 17th consecutive month in which more owners reported cutting average selling prices that raising them.

Components of the Optimism Index include: Labor Markets, Capital Spending, Inventory and Sales, Inflation, Profits and Wages, Credit Markets

The NFIB Report can be downloaded from the Sum2 website. NFIB Optimism Index

The NFIB Research Foundation has collected Small Business Economic Trends Data with Quarterly surveys since 1973 and monthly surveys since1986. The sample is drawn from the membership files of the NFIB.

Solutions from Sum2

Sum2 offers SME’s the Profit|Optimizer to  manage risk, devise recovery strategies and make better informed capital allocation decisions.

Risk: sme, small business, economic recovery

May 11, 2010 Posted by | credit, Profit|Optimizer, small business, SME, Sum2 | , , , , , , , , | 3 Comments

ADP Reports Weak Job Growth

ADP has released its National Employment Report for April.   Non-farm private employment increased 32,000 during  the month on a seasonally adjusted basis.   ADP also reported an upward revision of 19,000 jobs for March.  The two consecutive net employment gains reported by ADP indicates that job loss may have bottomed and the slim increase in employment confirms a positive trend is underway.     The massive governmental intervention to recapitalize the banking sector and initiate stimulus programs have stabilized the economy.  The abatement of extreme risk aversion in the credit markets, favorable interest rates, improving consumer sentiment, low inflation and the dramatic rebound in securities markets are all positive growth drivers for the economy.

Highlights of the ADP  report include:

Estimates non-farm private employment in the service-providing sector increased by 50,000.

Employment in the goods-producing sector declined 18,000.

Employment in the manufacturing sector rose for the third consecutive month by 29,000 jobs.

Employment in the construction sector dropped by 49,000.

Large businesses with 500 or more workers  added 14,000 jobs

Medium-size businesses, defined as those with between 50 and 499 workers increased by 17,000.

Employment among small-size businesses with fewer than 50 workers, increased by 1,000 in April.

Employment in the financial services sector dropped 14,000, resulting in over three years of consecutive monthly
declines.

Overview of Numbers

The net gain of 32,000 jobs for the massive US economy is an admittedly weak gain for an economy that has shed 11 million jobs but it is an indication that the economy is stabilizing.

The correlation of the loss of jobs in construction and financial services is an indication of a US economy that continues to transition its dependency on residential and commercial real estate development.  The difficult conditions in the commercial and residential real estate market will continue as excess inventories brought on by high foreclosure rates continue to be worked off.   As the ADP report highlights construction employment has declined for thirty-nine consecutive months, bringing the total decline in construction jobs since the peak in January 2007 to 2,159,000.  Its clear that the US economy has lost two critical recovery drivers.

Soft conditions in the construction sector weighs heavily on small business job creation.  Most contractors are small businesses and with the anemic rate of new housing construction small business job creation will continue to be soft.

Specialty retail is another large component of the small business market.  Improving consumer sentiment will help this sector.  However small retailers have suffered massive business closures during the recession.  A robust recovery in this sector will not commence until commercial lending for start ups and business expansion becomes more readily available from the banks.

The report also indicates that the goods producing sector of small businesses shed 24,000 jobs during the month  to continue the trend in the deterioration of small manufactures.  This decline was offset by a 25,000 gain in service based jobs.  The  growth of the service sector of the US economy continues at the expense of the manufacturing sector.  The growth of small business service sector indicates that businesses continue to managed fixed costs of their business by outsourcing various services.

This ADP report is a positive indication that we may be at a bottom of the economic cycle.  Bottoms don’t mean that things are improving they indicate that conditions are not worsening.  The economic recovery is still confronted with headwinds.  The oil spill in the Gulf of Mexico, the economic and growing political instability of EU countries and the cooling off of the Chinese economy may present some challenges to a sustained and robust recovery in the United States.

Solutions from Sum2

Sum2 advocates the establishment of an SME Bank to sustain long term economic growth.  Sum2 offers SME’s the Profit|Optimizer to help them manage risk, devise recovery strategies and make better informed capital allocation decisions.

For information on the construction and use of the ADP Report, please visit the methodology section of the ADP National Employment Report website.

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Risk: unemployment, recession, recovery, SME

May 5, 2010 Posted by | ADP, banking, credit, manufacturing, real estate, recession, small business, SME, Uncategorized, unemployment | , , , , , , , , , , , , , , , | Leave a comment

NFIB Small Business Optimism Report for April

The National Federation of Independent Business (NFIB) has just released the Small Business Economic Trends Report for April 2010. The report published since 1973 measures small business sentiment on numerous economic and business factors that confront small businesses.

This months report indicates a decline in business optimism. The NFIB index fell 1.2 points in March to 86.8 That’s up from the lows of March 2009, but has been below 90 for 18 months. The report reading is a contra indicator of economic recovery.  Small business owners are by nature and temperament optimistic and the report provides a sobering insight into the mind of US entrepreneurs and risk takers.

Highlights of the Report:

  • Jobs: After a devastating period of employment reductions, employment change per firm hit the “zero line” in March, setting the stage for a resumption in job creation. Nine percent (seasonally adjusted) reported unfilled job openings, down two points, a “negative” for hope that the unemployment rate will fall. Over the next three months, seven percent plan to reduce employment (down one point), and 15 percent plan to create new jobs (up
    two points), yielding a seasonally adjusted net negative two percent of owners planning to create new jobs, weaker than February and still more firms planning to cut jobs than planning to add.
  • Credit: Regular NFIB borrowers (35 percent accessing capital markets at least once a quarter) continued to report difficulties in arranging credit. A net 15 percent reported loans harder to get than in their last attempt, up three points from February. Eighty-nine (89) percent of the owners reported all their credit needs met or they did not want to borrow. Historically weak plans to make capital expenditures, to add to inventory and expand operations also make it clear that many good borrowers are simply on the sidelines, waiting for a good reason to make capital outlays and order inventory and take out the usual loans used to support these activities. Only five percent of the owners reported “finance” as their top business problem (up two points). Pre-1983, as many as 37 percent cited financing and interest rates as their top problem. What businesses need is sales, giving them a reason to hire and make capital expenditures and borrow to support those activities.
  • Profits: Reports of positive profit trends worsened by four points in March, registering a net negative 43 percentage points (39 points worse than the best expansion reading reached in 2005). The persistence of this imbalance is bad news for the small business community. Profits are important for the support of capital spending. For those reporting lower earnings compared to the previous three months (58 percent, up three points), 62 percent cited weaker sales, two percent blamed rising labor costs, five percent higher materials costs, three percent higher insurance costs, and seven percent blamed lower selling prices. Five percent blamed taxes and regulatory costs. Owners continued to reduce compensation at historically high rates, with 10 percent reporting reduced worker compensation and 10 percent reporting gains. Seasonally adjusted, a net zero percent reported raising worker compensation, only two points better than February’s record low reading of negative two percent.
  • Prices: The weak economy continued to put downward pressure on prices.  Seasonally adjusted, the net percent of owners raising prices was a negative 20 percent, one point better than last month. Plans to raise prices fell one point to a net seasonally adjusted nine percent of owners. On the cost side, five percent of owners cited inflation as their number one problem (e.g. costs coming in the “back door” of the business) and only three percent cited the cost of labor, so neither labor costs no r materials costs are pressuring owners.

Components of the Optimism Index include: Labor Markets, Capital Spending, Inventory and Sales, Inflation, Profits and Wages, Credit Markets

The NFIB Report can be downloaded from the Sum2 website. NFIB Optimism Index

The NFIB Research Foundation has collected Small Business Economic Trends Data with Quarterly surveys since 1973 and monthly surveys since1986. The sample is drawn from the membership files of the NFIB.

You Tube Music Video: Stevie Ray Vaughan, Couldn’t Stand the Weather

Risk: sme, small business, economic recovery

April 27, 2010 Posted by | recession, small business, SME, unemployment | , , , , , , , , , | Leave a comment

Get Ready for New Treasury Small Business Lending Program

economic_recoveryReuters reports that the U.S. Treasury will soon launch a new program aimed at aiding small business lending, the head of the Treasury’s $700 billion bailout fund said on Thursday.

Herbert Allison, the Treasury’s assistant secretary for financial stability, declined to provide details or specific timing on the program in testimony before the U.S. Senate Banking Committee.

The US Treasury has focused for the past year on stabilizing the banks with massive capital infusions into the sector with the TARP program.  The TARP seems to have succeeded in its goal to shore up the economic capital base of bank’s but lending activity to small and mid-size enterprises (SME)  has dramatically slowed.  Capital constraints and heightened risk aversion by commercial banks has curtailed access to moderately priced credit products for many SMEs.  Credit risk aversion and the recession has hurt the sector and has contributed to growing bankruptcy rates by capital starved SMEs.

SMEs employ more workers then any other business sector demographic.  One of the reasons the recession has been so severe is due to the massive layoffs and business closures within the by SME segment.   There are approximately 6 million SMEs in the United States.  If each SME hired one person that would put a serious dent in the unemployment rate.  Some statistics on the SME demographic includes:

• Represent 99.7 percent of all employer firms.
• Employ half of all private sector employees.
• Pay more than 45 percent of total U.S. private payroll.
• Have generated 60 to 80 percent of net new jobs annually over the last decade.
• Create more than 50 percent of non-farm private gross domestic product (GDP).
• Supplied more than 23 percent of the total value of federal prime contracts in FY 2005.
• Produce 13 to 14 times more patents per employee than large patenting firms.
• Are employers of 41 percent of high tech workers (such as scientists, engineers, and computer workers).
• Are 53 percent home-based and 3 percent franchises.
• Made up 97 percent of all identified exporters and produced 28.6 percent of the known export value in FY 2004.

(Source: Cornell School of Industrial and Labor Relations, Basesky and Sweeney)

The US Treasury program will target the SME segment and direct capital to help lead the economic recovery.  SMEs are the leading source of job creation, product innovation and wealth creation.  A vibrant and financially healthy  SME sector is key to any sustainable economic recovery.  This program will also help to bolster the ailing community banking sector that has seen over 95 closures by the FDIC this year.

It is critical that SMEs prepare to participate in this program.    Sum2 offers a complete product suite to help SMEs capitalize on the many opportunities economic recovery will present.  Sum2’s recently announced webinar series “Recovery Tools for a New Economy” offers SME critical management tools to profit from the emerging business cycle.

As the lending program to SME rolls out, bankers will initiate engagement process and business reviews.  They will be  looking to determine if SME managers have identified risks confronting their business.  It is incumbent on small business managers to understand how changing market dynamics and operational risk factors are impacting their business and demonstrate how they will mitigate these risk factors.

Sum2 provides a series of risk assessment products that assist companies to chart paths to profitability and growth.  The Profit|Optimizer, is a unique risk management and opportunity discovery tool that helps SMEs effectively manage the challenges posed by the recession and recovery business cycles.

Risk:  SME, recession, recovery, stimulus, commercial banking

September 25, 2009 Posted by | banking, credit, FDIC, recession, risk management, TARP, Uncategorized, unemployment | , , , , , , , , , , , , , , , , , , , , , | 3 Comments

Avoiding Bankruptcy

bankruptcyThe soft economy, the rise of inflation and the curtailment of credit is having a dramatic effect on small businesses. Annual bankruptcy rates among small businesses is sky rocketing. As the recession continues small business bankruptcy will continue to rise.

Bankers are undertaking a comprehensive review of their small business loan portfolios to enhance risk mitigation programs. They are increasingly driven to engage their small business clients to determine if they can detect any problems that is affecting their clients financial health. Poor operating performance leads to a distressed condition that can ultimately lead to insolvency.

Banks are becoming more proactive. Small business managers need to take action to uncover the factors that are damaging the business.  They must recognize the early warning signs of an emerging distressed condition to remain in the good graces of bankers by honoring the parameters of existing loan covenants.

Banks are taking the lead.  Bankers are initiating an effective engagement process by conducting business reviews  that disseminate information and provide tools to help businesses identify sources of risk in clients business operation. It is incumbent on small business managers to understand how changing market dynamics and operational risk factors are impacting their business and more importantly demonstrate a willingness to take steps to mitigate these factors

The problems posed by curtailment of credit and rising unemployment pose acute threats to small businesses. This is particularly true for businesses that cater to retail consumers. The erosion of consumer buying power due to loss of income and evaporation of customers credit lines means that they won’t be purchasing goods and services offered by small businesses.  Small business sales and profitability evaporates due to exposures to these risk factors.  Small businesses must devise strategies to address these types of risks.

Bankers need to be involved with their small business clients to determine how these risk factors are affecting business profitability and what steps need to be taken to temper their effect.  This a great opportunity for bankers to enhance their engagement level with small business clients. The exercise will preserve relationships, mitigate potential credit defaults and build the banks brand as an effective and involved partner to small businesses.

Sum2 provides a series of risk assessment products that assist companies to chart paths to profitability and growth.  Please visit our website to learn more about the Profit|Optimizer, a unique risk management and opportunity discovery tool that can help you more effectively manage the challenges posed by the recession.

You Tube Video:

risk: credit, bankruptcy, banking, SME

August 20, 2009 Posted by | commerce, credit crisis, recession, SME, unemployment | , , , , , , , , , , , , , , | Leave a comment

$700 Billion is a lot of Guacamole!

paulsonAn article in today’s  Forbes online entitled Trouble with TARP,  reports a growing concern by the Congressional Oversight Panel (COP) about the effectiveness of the $700 billion program.  The COP reports that the effectiveness of the program is difficult to determine due to lack of transparency of how funds were spent.  The COP report also states that the absence of any reporting guidelines for TARP participants impedes effective oversight.

The 145 page report starts with a retelling of the extreme conditions confronting the banking sector as the credit crisis exploded last autumn.  It also outlines the choices confronting regulators, legislators and industry executives as the crisis deepened.  We were led to believe by Treasury and Federal Reserve officials that the global banking system was in imminent  danger of collapse.  Nothing less then immediate and drastic measures taken by sovereign government officials and industry executives would prevent the catastrophic consequences of global economic carnage.  The report makes it clear that these market conditions were so extreme that regulators were navigating through uncharted waters.  Any remediation measures taken had little historical precedence to guide actions.  Hence Paulson was given carte blanche to handle the crisis with unprecedented latitude and executive facility.

As this blog reported earlier this week, the TARP was originally designed to acquire troubled assets from banking institutions.  TARP funds were earmarked to purchase mortgage backed securities and other derivatives whose distressed valuations severely eroded capital ratios and stressed banks balance sheets.  Hank Paulson later shifted the strategy and decided to inject TARP funds into the banks equity base.  This has done wonders for the shareholders of the banks but troubled assets remain on the banks balance sheet.  As the recession continues,  unemployment, home foreclosures, SME bankruptcies and the looming problem with commercial mortgage backed securities  (CMBS) are placing a new round of added strain on the banking system.

The TALF program is designed to draw private money into partnership with the government to acquire troubled assets from banks.  So far the program has received a tepid response.  I suspect that the principal factors inhibiting the expansion of the TALF program are numerous.  Chief among them is the inability of FASB to decide upon valuation guidelines of Level III Assets.  Banks holding distressed securities may also be reluctant to part with these assets because they have tremendous upside potential as the economy improves.

The COP also questioned the effectiveness of TARP because stress tests were only conducted on 19 banks.  The report states that additional  stress tests may be required because the previous tests failed to account for the length and depth and length of the recession.   Community banks are also of concern.  They face a perfect storm in challenging macroeconomic conditions.  Of particular concern is commercial real estate loans.  Many economists are concerned that high rate of loan defaults in commercial loan portfolios pose great threats to the community banking sector.

Though interest rates remain low due to the actions of the Federal Reserve,  lending by banks still remains weak.  SME’s are capital starved and bankruptcy rates are quickly rising.  SME’s are critical to any economic recovery scenario.  A strong SME sector is also crucial for a vibrant and profitable banking system.  Perhaps a second round of TARP funding may be required to get more credit flowing to SME’s.  If banks start failing again it would be devastating.  The Treasury and the Federal Reserve don’t have many bullets left to fire  because of all the previous expenditures and a waning political will of the people to continue to fund a systemically damaged banking system.

Risk: banks, SME, economy, credit, market

You Tube Video Music: Billie Holiday with Lester Young, Pennies from Heaven

August 13, 2009 Posted by | banking, credit crisis, economics, FASB, Paulson, real estate, recession, regulatory, SME, TALF, TARP, Treasury, Uncategorized, unemployment | , , , , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

Job Loss Decelerating?

ADP has released its  National Employment Report for July reporting a 371,000 decrease in non-farm private sector jobs.  ADP has also revised its numbers for May from a decline of 473,000 to a decline of 463,000.

The ADP report states, July’s employment decline was the smallest since October of 2008.  As a trailing economic indicator, unemployment is expected to continue to rise for the next few months.  As the recession recedes and the  economic recovery takes hold employment is likely to decline for at least several more months, albeit at a diminishing rate.

Highlights of the report include:

The report estimates non-farm private employment in the service-providing sector fell by 202,000.

Employment in the goods-producing sector declined 169,000, with employment in the manufacturing sector dropping 99,000, its smallest monthly decline since September of 2008.

Large businesses, defined as those with 500 or more workers, saw employment decline by 74,000, while medium-size businesses with between 50 and 499 workers declined 159,000.

Employment among small-size businesses, defined as those with fewer than 50 workers, declined 138,000.  Since reaching peak employment in January 2008, small-size businesses have shed nearly 2.4 million jobs.

In June, construction employment dropped 64,000.  This was its thirtieth consecutive monthly decline, and brings the total decline in construction jobs since the peak in January 2007 to 1,483,000.

Employment in the financial services sector dropped 26,000, the twentieth consecutive monthly decline.

The full report can be accessed here:  ADP National Employment Report

Risk: unemployment, recession

August 5, 2009 Posted by | economics, manufacturing, recession, SME, Uncategorized, unemployment | , , , , , , , , | Leave a comment

The Yin and Yang of Inflation

Yin YangInflation like all risk is a double edge sword. Its negative nature will upset the apple cart and pose uncomfortable challenges for business managers that have grown accustomed to the status quo. It will force managers to reconsider their well conceived business plans and perhaps more closely scrutinize this quarters P&L or the company balance sheet. It will present serious challenges for businesses supply chain and client relationships. It may raise the eyebrows of your shareholders and credit providers perhaps provoking some pointed questions concerning your management skills and the validity of your business model.

That said inflation does have an upside. Like all risk factors it has the potential to create opportunities for your business. Inflation will drastically alter market conditions. It will reveal inefficiencies that nimble businesses can actively engage and manage to turn those market conditions to their advantage. The key operative words are management, intentionality and active engagement.

Inflation is a silent killer. It stalks all businesses threatening to gobble up product margins, revenue opportunities and bottom line profits. It diminishes customer buying power and may threaten the solvency of your largest customers and suppliers. It drives up the cost of capital, making credit more expensive while it forces state and local governments to raise taxes and fees.

The inflation bogey man lurks in the profit and loss statements of all businesses with small business being particularly vulnerable to its effect. Inflation dramatically shows itself on the expense side of the ledger in the increases for basic materials, energy, delivery services, T&E, administrative expenses and employee benefits. Inflation also affects the income side of the profit loss statement. It erodes the buying power of your customers and threatens collection of receivables by extending days outstanding, increased write offs or the sale of uncollected debt for pennies on the dollar.

Small business profitability is particularly sensitive to the effects of inflation because of economies of scale, concentration of risk factors and lack of pricing power.

Many small businesses lack pricing power. Pricing power suggests that if price of a product rises to a certain level demand for that product will not diminish. For a small business to have pricing power it must offer a non-commoditized product to dependent buyers. Its product or service cannot be easily replicated or widely available from other sources.

While pricing power escapes most small businesses numerous factors inhibit their ability to become low cost producers. They deliver product or service differentiation to their customers by other means then low price. Inflation erodes consumer purchasing power driving buyers to seek low cost producers. In this environment small businesses may suffer when buyers trade down to low cost providers. Key customers may compel small businesses to lower prices to be more in line with lower cost producers. This is a major threat to small businesses.

Small businesses tend to have greater risk concentration in their business model. Heightened risk concentrations are most pronounced in small businesses due to a limited product line, geographical risk, market cyclicality and in client and supply chain relationships. Consider a small manufacturer of finished steel products for the home construction industry. Generally, manufactures profitability is highly correlated to the price it pays for basic commodities and has an extremely high concentration of supply chain and product risk. Small businesses may not be able to recover or adjust its product prices to cover increased commodity prices due to existing contractual agreements with customers or its lack of pricing power. The abatement of market demand due to a recession may provoke larger customers to demand price concessions by threatening to move their business to lower cost producers. The pressure on this small manufacturer is compounded by a spike of smaller account losses and moribund demand due to weak cyclical market conditions in its target market.

It’s almost a perfect storm of negative business conditions. Small businesses managers need to understand how inflation touches all aspects of their business and must manage its impact to maintain profitability and sustainable growth.

Managing Inflation Risk with a WIN Campaign

Small businesses can meet the challenge of inflation head on by implementing a Whip Inflation Now (WIN) program that engages the numerous risks inflation poses. In deference to our former President Gerald Ford, business managers can initiate WIN Programs and actions to temper the impact of inflation and to seize opportunities that rapidly changing market conditions create. Small businesses must be extra vigilant and proactive in managing all classes of business risks.

Some small businesses will cave into the demands of their large accounts to cut prices to prevent them from going to a lower cost provider. This is very dangerous for small businesses and can result in “death by a thousand cuts.” Managers should not wait for their largest account to approach them seeking price concessions. Now is the perfect time to go on the offensive and alter the value proposition that only your firm can uniquely deliver to key accounts. Remember your largest accounts are experiencing the negative effects of inflation as well. Go to them and propose a WIN Campaign. A company’s WIN Campaign can offer a joint marketing program using WEB 2.0 techniques. Your WIN Campaign can implement an expanded training and support program tied to a business development program or supply chain rationalization. You may suggest a partnership to develop a new product or put in place a customer loyalty program. Your job is to create a unique value proposition that adds value to your product and convey it to your customer so they cannot commoditize your product. Together you and your clients can WIN the fight against inflation and turn it into a business development initiative. Your clients will appreciate the fact that you are thinking about their business success.

Another common knee jerk reaction to fight rising business costs is to reduce expenses by cutting expenditures on areas that do not support the mission critical functions of the business. Capital is allocated to maintain funding to support sales, production and product delivery. This is coupled with a lean administrative management structure and this model is seen as a recipe for economic survival. Being good stewards of corporate capital is essential during these times. Capital leakage is always a threat to business profitability and needs to be even more diligently managed during times of economic duress. But this strategy is a subsistence survival strategy. It is based on investing the barest minimum of capital to address fluctuating market conditions. This strategy may limit small businesses ability to literally capitalize on opportunities that changing market conditions present.

Cutting expenses for marketing is usually another budget casualty when businesses look to cut costs. This will reduce your current expense line for this quarter and will certainly help bottom line profitability; but skipping this year’s trade show will not help you to locate that new customer who is looking for a supplier because his current provider is struggling with product quality issues. Cutting this expense won’t provide you with the critical insights you need to stay competitive and ahead of new market entrants that are attending trade shows. Who by the way are also aggressively courting your largest account to get just a tiny slice of your business to demonstrate their “superior value proposition.”

Employee benefits and training is another area that is often the focus of budgetary cutbacks. Many small businesses need to closely consider the gains they will realize by cutting back on benefits offered to its employees. Cutting benefits could increase employee turnover. Training and hiring new employees are an expensive proposition for small businesses. The loss of key employees can potentially devastate a small business. Expertise, intellectual capital and critical business intelligence leaves the organization when a key employee walks out the door. This is doubly true if some key employees leave the firm and walk some major client relationships out the door with them.

Small businesses can also try to employ risk transfer strategies. Insurance purchases may help in some areas but to fight inflation small businesses can use financial instruments (capital permitting) to hedge against rising prices. The purchase of TIPs, FX forward contracts, commodity or energy futures can help to offset the negative effects of key inflation business threats. As the price of oil rose this summer a modest equity position in oil or other energy company would have helped to offset the increase in energy expenses.

Thankfully adverse economic conditions will force small businesses to take an honest look at their product lines and business model. Economic adversity provides an opportunity for management to make hard decisions concerning product lines. This is an ideal time to focus and fund the development of products that offer the greatest potential for long term profitability and sustainable growth.

Inflation is a significant problem for small businesses but it is a problem that can be managed. Changing economic conditions alter the landscape for all businesses that accelerate and starkly reveal market inefficiencies. These inefficiencies create market anomalies and opportunities that astute small business owners and managers can capitalize on through an intentional practice of a risk management and opportunity discovery program.

June 20, 2008 Posted by | business, commodities, credit crisis, economics, inflation, product, recession, risk management, SME, supply chain, US dollar | , , , , , , , , , , , , , , , , | Leave a comment