Part
Three - Profitability
Following
on from the last chapter where we mentioned trading
losses, I think it is generally accepted that
people go into business to make money or profit.
It
is this profitability and what is done with it,
that the banks will look at to determine the debt
servicing ability of the business.
One
critical calculation the banks will do is the
one called interest cover. It goes like this:
Net
Profit + Interest cost divided by interest cost
= interest cover.
For
example, say net profit is $55,000 and Interest
costs are $22,000
$55,000
+ $22,000 = $77,000
$77,000/$22,000
= 3.5
Interest
cover in this example is 3.5 times, something
the banks would be happy with. Anything under
2 times would suggest to the banks that the business
had too much debt and/or that debt servicing was
under pressure.
Another
debt servicing calculation is based on the Cashflow
of the business and is generally taken from the
Profit and Loss section of the annual accounts.
This
is based on net profit being added to interest
costs and then the non-cash costs being added
back; this is generally depreciation, but could
include other non-cash costs like amortisation
of goodwill etc. It is important to note that
shareholders' salaries come off this figure before
debt servicing is determined.
For
example: say net profit is $55,000 (before shareholders'
drawings/salaries), Interest costs are $22,000,
and depreciation $15,000 and shareholders' salaries
are $60,000 (it is important to know whether the
Net Profit is before Interest, Tax and Depreciation).
This is usually referred to as EBIT, (Earnings
before Interest and Tax) or EBITD, (Earnings before
Interest, Tax and Depreciation). For the sake
of this example net profit is EBITD but before
shareholders salaries.
Net
profit $55,000
Add back Interest $22,000
Depreciation $15,000
Total $92,000
Less
Shareholders' salaries $60,000
Leaves
$32,000
If
debt servicing (and this includes interest and
principal as the banks like to see debt levels
reducing) is greater than say $30,000 then you
are likely to experience problems from the bank
with regard to approval for new lending or continuation
of existing facilities. Not only is there not
much margin for the business but also shareholders'
salaries are greater than the available Net Profit.
The net effect of this is the equity held in the
company is diminishing. This is covered more fully
in a later chapter.
Another
aspect of profitability is the trend analysis.
By comparing year on year results trends become
evident and this is why banks will ask for three
years of accounts.
The
main ones looked at under profitability are gross
profit and net profit, year on year. But more
importantly the gross profit to sales percentage
and the net profit to sales percentage, show how
the business is doing and is the business holding
its margins.
