Economic Concepts II

Understanding Risk and Reward

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On a drive in Montana one of my closest friends, a business owner himself, asked me why most businesses fail.  He knew I had built Key Consulting, Inc. working with companies in financial trouble.  I had also invested my own money in businesses and ran them myself.
 

My answer surprised him.  I told him, "most people simply do not understand the size of the risk they are taking and when it unwinds, it unwinds fast...".

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So we look at Risk vs. Reward I to the left.  As the company takes more risk (expansion, debt, an acquisition), the potential reward (money, % return, long-term value) increases as well.

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So far so good.

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Let 's take a look at the same graphic with a real-world scenarios.

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Let's say the revenue stream is there and you wish to expand.  How does an expansion and the financing of the expansion affect your position on the risk-reward line?  You are currently safe in the highlighted area with relatively low risk and relatively low reward.

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So to double your plant or office or real estate portfolio, you have three choices for financing.  One is existing cash.  One is a combination of existing cash and new debt.  One is all debt using the existing business assets as collateral.

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Using existing cash does in fact move the company up the curve.  If the business cannot fill capacity, the expansion runs over budget, or if an alleged pandemic (COVID) hits, disruption occurs.  The company will have risked the safety of cash on hand to pay for the expansion.  The risk profile of the business is greater...even when cash is used.

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Using cash/new debt in some combination moves you further up the curve.  Why?  The cash you are using and risk of added debt (which stays regardless of the outcome of the expansion).  So if risk is increased, why is reward increased?  You have, as the street term goes, used "the other guy's  money" to gain the higher return.  You repay the 6% loan and the rest of the increase in profits is yours, increasing the total return.

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Finally, using all debt for an expansion.  I admire guts, but there is a line between guts and insanity.  So under this scenario, the company borrows the entire cost.  If the project hits, then the bank is repaid and all the remaining gain belongs to you.  There is the increased reward.  The risk portion has also increased because if you used the existing business assets and cash flow, they are now at risk for seizure if the project wounds the business.

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So the safe play is obviously to do nothing and stand pat, right?  Absolutely not.  There is also risk in doing nothing.  Not all risk is adding bank debt or buying a new building.  Today, our world moves faster than ever.  Technology.  Consumer preferences.  Political winds. 

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Take a look at the final chart.  It shows the risk of a company in stagnation.  A company that is frankly resting on it's laurels.  Little if any growth exists.  Staff may leave.  The customer base is unchanged. 

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In the military, I attended lot's of schools.  One in particular was pretty tough.  One of our instructors stressed that gaps on the battlefield exist for only minutes or hours.  It is crucial we are prepared to exploit opportunity when it is in front of us.

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Business is no different.

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Think about risk.  Think about reward.  Think about the location of your business on that line.  Where are you?  Where are you going?  Are you at more risk than you understand?

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