Financial Advice from a Business Veteran
In these difficult economic times, CPAs should take a more active role in guiding a company's financial affairs-especially in capital management. So says John R. Meinert, chairman emeritus of Hartmarx Corp. and Hart Schaffner & Marx. He also draws on over 20 years' experience as chief financial officer. Since retiring last year from Hartmarx, he has launched a new career as a principal in the J.H. Chapman Group, Ltd., an investment banking firm in Rosemont, Illinois. A WIDER ROLE FOR CPAs Some CPAs see their role in capital management as minimal. Too many limit their job to gathering and reporting historical data-accounting for what happened, not laying out the design for what will happen. That's unfortunate. CPAs have a unique skill that they can and should bring to bear on financial matters. At the very least, CPAs should apply their analytical skills and play the devil's advocate, questioning the source of corporate forecasts, ferreting out false premises and observing when emotions are overwhelming better judgment. To be sure, that's a difficult role to play. But it's worth the candle: It can enhance a business's fortunes and the accountant's professional status. In this way CPAs can add respect for their financial acumen and business judgment and gain more decision making responsibility. One area in which they can apply their skills is the management of capital. Here is some useful guidance. CORPORATE DEBT STRATEGY GONE BAD Debt has been getting a lot of bad press lately. That's because some companies have been borrowing excessively when they should have been building equity. Now they're paying the price for those errors. Other, more conservative businesses are being hurt by the spate of negative publicity: Overly cautious lenders deny credit even when it would be used for the right reasons and structured in the right way. In effect, these lenders have been demanding that borrowers demonstrate both a good cash flow and a strong asset base; that's like wearing both a belt and suspenders. Corporate America's rush to debt was understandable, though imprudent. After all, the least expensive way to raise capital-after accounting for taxes-is with debt. This was a major incentive behind junk bonds. To better appreciate the lure of corporate debt, assume the following: A debt-free company is in the 40% tax bracket, generating a 12% return on equity. Assume, too, that 80% of its equity is replaced with debt at an interest rate of 15% (9% after taxes). That company's return on equity doubles to 24%! If the company could borrow at 12%, or 7.2% after taxes, the return on equity would climb to 31.2%. Earnings before interest and taxes (EBIT) are unchanged, so all the gain in both examples is from tax savings, which effectively lowered the cost of capital on the 80% debt segment. By using such financing to dictate their actions, many businesses pushed their debt leverage to extremes, even to the point of ending up with negative book values. What many executives failed to appreciate is that growth at any cost may be too expensive. When debt exceeds a business's ability to carry it, or when related interest consumes the earnings, management probably has exercised poor business judgment. Management's goal should be increasing profit for shareholders, and the only way debt can make financial sense is when its cost, after tax, is lower than the resulting return on equity. BUY-BACK OR EXPANSION Some publicly held companies with low stock values-say, below book value-buy back their stock to increase per-share earnings and book value with debt that costs them, after taxes, less than their return on equity. While such buy-backs may be attractive investments, management can be faulted for not finding attractive expansion opportunities instead. Until recently, the risk of growth via debt was concealed by fast appreciation of assets, swelled by inflation and speculation. …