I don’t get it.
In many cases, I don’t get the way that business is done.
In our private lives, we are told to pay off debt.
We are told to pay off debt, we are told to save for the future, and we are told to diversify risk.
But what about companies?
Having no debt means you are not subject to anyone, and you need less income to exist. $4,000 in monthly spending and $2,000 in monthly debt payments? In this case, a person, or family, needs $6,000 to get by. Without debt, only $4,000 is needed to live.
That is as straightforward as it can be.
Saving for the future means that you maybe have a little security. This is why people like Dave Ramsey recommend an emergency fund. Refrigerator break? Need new tires? Find out kids need braces? Lose your job? You can have a different perspective on each of these with $40,000 sitting in a checking account for the just-in-case. Cash is king. And having a giant pile of it is like a breath of fresh air.
Finally, diversification. How many times are we told to diversify our investments? One would be crazy to put all their 401K in one company. For what happens if that company goes bankrupt? Few are willing to risk their entire retirement on one company. And why should they? So if income from one investment dries up, it should not be a big deal. That investment should only be 5% or less of your portfolio.
And then here is where I get lost:
If no debt, savings, and diversification are smart for an individual and family, why is it not also smart and sensible for a business entity?
I submit that it is.
But in the same way that few individuals stay away from debt, have large cash savings, and diversify their investments, few businesses manage to do the same.
I understand finance. I understand the role banks play in leverage. I know how to calculate an internal rate of return and look at “good” debt vs. “bad” debt. But more fundamental than all that: Debt weighs you down. It ties a weight around your neck. Debt increases your fixed costs and makes your firm more fragile to a market or industry disruption. In general, businesses should stay away from debt.
On an emergency fund, just as a person should – a business should be saving during times of plenty. What if your business saved 15% of it’s profits? What if during the next economic downturn your firm had a few million in cash? During the next economic hick-up, your competitor is going out of business, and you are buying him out for pennies on the dollar.
Businesses should also diversify their income streams. I understand core competencies. I understand that businesses are usually bad at things they have never done. But, I also understand risk. For instance, Google is probably not looking to get into the tobacco business anytime soon. But that doesn’t mean they can’t own a few million shares of Altria or Philip Morris in the name of diversification.
In all of this, my rub is, for example, with some company that has been around for a few decades and doing quite well. Say they are in the oil business. Oil prices are high and they are swimming in cash. What is usually done? They hire more people, borrow money, drill for more oil, and maybe pay some dividends.
They should be making themselves bullet-proof.
1. Take the extra cash and pay-off all debt.
2. Use extra income to build a cash war-chest.
3. Diversify income streams.
Can you imagine some medium-sized oil company looking at low oil prices and shrugging?
Some CEO says:
“Low oil prices are not a large issue to us. We have no debt, we have enough cash to operate without income for quite some time, and 60 percent of our income is outside of oil.”
60 percent of your income is outside of oil?
“Yes. We have $500 million invested in Procter and Gamble, AT&T, Coca-Cola, General Electric, and a few others, generating about $1.7 million per month in income for us.”
Like I said, in this case, what is good for the individual and family is also good for the firm.