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Every formula must be examined in the context of the moment
I heard on the radio recently that the S&P was up 28 percent since October first. That may not be exactly correct but it will still make my point.
Following formulas that may be valid in the long run may hurt you in the short run. If you rebalanced your portfolio in September to reduce risk, you may have suffered some lost opportunities. Timing is everything. The question is: Who is picking the time?
One of my favorite concepts in money is the question of a thousand dollars and its relativity to other numbers. It is a lot of money to a start-up business. It is petty cash at GM.
Formulas and ratios must be viewed in the total picture of the events and circumstances surrounding the financial analysis.
A balanced portfolio says you should have your investments at certain ratios to give you a reasonable gain while protecting you from a down market. That’s unarguable except for timing. If you are heavy in stocks and rebalance in a stock market trough, you are not going to be pleased with the results.
Every formula and ratio must be examined within the context of what is going on at the moment.
The stock market acts independent of any thing you can do, and the people who try to time it might as well use fortune cookies to tell you when to get in and out of the market. The formulas used to balance portfolios apply over a matter of years — not days, weeks or months.
What about your own business? How do formulas, ratios and margins apply there?
In this case, you control the numbers. You look at numbers in the context of the situation. A current ratio of 2-to-1 is desirable. The current ratio measures your ability to pay your debt over a 12-month period. It may not be attainable in a growing business. If you maintain a large cash balance, you may be a great short-term credit risk but a long-term loser in profitability.
There are industry standards for profit margins. What if the product won't sell at that price? It doesn't matter what the standard is if the product won't sell. So you must make decisions based on cutting overhead to generate a profit at a lower gross profit and hope your competition follows the industry guidelines.
My father used to say that if you were going against the grain, you were probably doing the right thing because most people lack intelligence.
Debt to equity is an interesting number. It measures who is more at risk — you or your creditors. In a perfect world, the balance would be equitable. That is usually not the case.
Many entrepreneurs would prefer that creditors carry all the risk. What is amazing is that in big business, the greatest rewards are to executives with no risk. Nice if you can get it.
In a perfect world, risk and reward would be perfectly matched. This is not a perfect world.
Remember that for its risk, the bank is limited in its reward to an interest rate. That is why the bank is not as enthused as you are about the rewards.
Norms, goals, standards, etc., have value. They are not, however, the answer to questions. They raise questions to which you must find answers.
If you don't meet certain averages, it may be that you are better than someone else. If you are below the standard or average, you need to find out why and if the situation is controllable. If the situation is not controllable, you will have to make some decisions. The reason you need to look at standards is so that you know that a decision needs to be made.
In a nutshell: Think!
Paul Hense is the retired president of local accounting firm Hense & Associates, now Hense & Bowman. He also is past chairman of the Small Business Association of Michigan.