The other day I was talking to a few local business owners and I asked them if they knew what their cost of capital was. I got a few blank stares.
When we discussed the issue further, people started to warm up to the idea that the cost of capital can be viewed in terms of opportunity costs:
1. One owner said his cost of capital was the interest rate on his bank loans. I suppose he was 100% debt financed and probably not planning to refinance any time soon! Good luck to him!
2. A second owner said he took out all his savings from the bank and put it into his business. Since the bank deposit rate was so low, he figured his opportunity cost was pretty low as well. He has a point, though he must realize that he has moved into a higher risk category by withdrawing his money from the bank and investing it in a start-up business.
3. Another business owner said he started his company by borrowing from his relatives. Since they haven’t asked for it back he assumes its cost is zero. But he does pay a price, I suppose: at family gatherings he gets dirty looks from his relatives and his wife gives him constant grief. He suspects that the relatives complain about him to his wife.
Since all three owners want to expand their businesses, they asked me if I could recommend new sources of finance. I thought of sending them to our P4 candidates (after the exam!).
https://www.theexpgroup.com/wp-content/uploads/2018/06/styleguide-EXP-4.png00Stevehttps://www.theexpgroup.com/wp-content/uploads/2018/06/styleguide-EXP-4.pngSteve2009-09-26 19:25:522009-09-26 19:25:52Do you know your cost of capital?
So, how am I doing weight wise? More to the point, what has this got to do with the exams?
Ratio analysis is an important area of the syllabus and one overriding principle to remember when looking at ratio analysis is that a ratio is irrelevant when looked at in isolation. Ratios must be looked at against comparatives or benchmarks in order to interpret them and then to look at the underlying causes.
So, back to my weight of 85kg. How am I doing? Is my weight ok?
85kg by itself is irrelevant. We need to look at comparatives for somebody who is my gender and my height. For example, 85kg for an adult male with a height of 1.90m (6 foot, 3 inches) is a healthy weight. 85kg for an adult female with a height of 1.60m (5 foot, 3 inches) is an unhealthy weight with the person being classified as obese.
Using my example of 85kg, by comparing it with people who are the same height as me is in effect comparing it with “industry standards”.
What about my performance over time? Is my weight increasing, decreasing or remaining static when compared to last year and the year before. Comparing movements within this personal ratio analysis unfortunately reveals that my weight has increased.
Now onto the important issue behind ratio analysis and that is of looking at the underlying cause of the movement in the ratio. Unfortunately, it looks like the cake I have with my afternoon tea could be on the way out…
https://www.theexpgroup.com/wp-content/uploads/2018/06/styleguide-EXP-4.png00Stevehttps://www.theexpgroup.com/wp-content/uploads/2018/06/styleguide-EXP-4.pngSteve2009-09-02 18:32:532009-09-02 18:32:53My 85kg and ratio analysis…
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