All businesses make investments in both plant and equipment, and also in their employees. Depending on the type of enterprise, some businesses will have more invested capital than others. For example, a manufacturing oriented business will have substantially more hard physical capital invested than one devoted to service. No matter the type of business, the primary question remains the same. The question is— what is the purpose (or goal) of any business investment? The answer— the purpose of any investment is to increase the net worth of that investment.
Then, how do you accomplish this? This is accomplished by maximizing the return on invested capital. Unfortunately, therein lies the rub. By maximizing your rate-of-return on invested capital you also maximize your business risk—- and also your competition. If you wish to shoot for high returns, then you have to accept a higher level of risk. If you can concisely take all the wisdom in the world and melt it down to a single sentence, it would read — there is no such thing as a free lunch. (Although, at times, it is possible to transfer the cost to someone else.)
If you are in the business world you have to accept risk. Business is risk. There is a difference, though, of shooting for the moon and taking a calculated risk. The financial debacles of both Enron and Global Crossing illustrate an important point. Both companies decided to utilize large amounts of leverage (debt) to quickly expand both their top and bottom lines. In their conceit they forgot one important rule when utilizing debt. Even the ancient Persians know that LEVERAGE IS A TWO-EDGED SWORD. When business conditions are in your favor, leverage can rapidly expand both your top and bottom lines.
Market economies are characterized by turbulence and chaos. They are not well behaved organisms. In other words they are not linear. They are not predictable. Most likely, it is not a question of will the business environment change to adversely impact your original plans but when. When this happens, reverse leverage can cut you to ribbons.
The bankruptcies of Enron and Global Crossing plus the difficulties Tyco International encountered all were based on what I call corporate swagger. Assuming an optimistic business scenario, they all took on an enormous amount of debt to expand their businesses rapidly. Due to their overconfidence they did not ask the suitable question when they were ballooning their debt to equity ratios. This question is— if the market conditions change (they will), can we manage the burden of this debt without hitting the ropes and going down. If this question was initially asked, they and many others could have saved their stockholders and employees much grief.
A business example that illustrates the role of investment suitability is the misadventure of Pacific Enterprises Corp. In the l980’s Pacific Enterprises, a large gas utility holding company in southern California, bought the retail drug chain Thrifty Drug Corp. (now part of Rite Aid). The company thought they could easily transfer their expertise of managing a utility over to the retail drug business. Bad decision! They overpaid for the retail drug chain by issuing a large amount of corporate debt. In addition, they knew nothing about the unique problems of managing a retail drug establishment. They simply got too far afield from their core business. Their losses started to grow and the company’s stock value plummeted. Pacific Enterprises was forced to sell Thrifty Drug Corp. at a sizable loss. The investment they made in Thrifty was not a suitable one when compared to their core business.
The nexus between business risk and maximizing your rate-of-return is suitability. Suitability is the most important investment criterion whether on a personal or business level. Not only does it concern the investment that is made, but also how it is financed. Is it financed by taking on a substantial amount of debt or by equity capital (common stock or internally generated funds for example)?
Which one is for you? Debt is more risky, but allows for faster growth. Equity financing is not as risky and hence allows for more stable growth. Without asking yourself the question as to whether this particular investment is suitable to my operation, you may make reckless business decisions that do not mesh with sound financial management and your basic business philosophy.
My latest book is The Thirteen Great Economic/Business Myths That Dominate Our lives.The book is available on most popular book web sites (amazon.com).