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Published on August 4, 2003

Don't forsake equity to reduce taxes It's a source of strength that helps a business stay afloat

Although tax advisers perform a critical function in managing a tire retailer's business-and their advice is invaluable-I've seen too many cases in which a tire dealer manages his business with the single-minded purpose of lowering his tax bill.

This strategy can do a great deal of damage to your business.

I'm oversimplifying a bit, but the main way to lower your taxes is to lower your business' reportable profits. But lowering your profits also reduces a key source of your funding.

Your business has only three sources of funding:

* Cash contributed as capital from the owners (you and your partners);

* Profits from the business that are retained; or

* Loans from banks or from owners as stockholder loans.

The first two combined are equity, the last is debt. So any strategy that doesn't attempt to generate a healthy level of profits-and retain those profits-will lower the owners' equity in the business.

Importance of equity

Why is equity important?

* Equity provides a cushion for the tough times.

* Equity buffers unexpected fluctuations in working capital needs.

* Equity provides the base for sound sales expansion.

* Equity, not to mention a track record of profits, becomes especially important if you decide to sell your business.

Unfortunately, many of us know all about tough times. During the past two years or so, many tire dealers have experienced their first sustained sales decline in a decade.

If you entered this period with a relatively high amount of equity, then one or both of the following was probably true:

* You had a healthy amount of working capital-that is, cash and other assets that could be easily converted into cash (accounts receivable and inventory) minus the bills you owed and other short-term obligations.

* You also didn't have much debt other than accounts payable and accrued items.

Both of these conditions are a source of strength when business slows. If your sales flatten or decline, it helps to keep your borrowing low. The money you're not spending on interest payments lowers your expenses.

Even during ``normal'' business conditions, your need for working capital can spike from time to time due to the cyclical nature of the tire business. A piece of equipment breaks down and needs replacing, or you grant generous payment terms to attract some new customers, or you need to replace some outdated inventory-any of these will tap into your working capital.

Working capital a key

Your equity gives you the ability to support working capital needs as they change and helps to keep your business afloat.

Working capital is especially important in the tire business for two reasons. Tire dealers tend to have a higher percentage of current assets and liabilities than other businesses.

The ideal range for working capital as a percent of sales is in the range of 10 percent to 15 percent. Most financially sound tire dealers can exist on 6.5 percent to 8.5 percent if they do a good job of managing accounts receivable and inventory investment. Tire dealers tend to be undercapitalized, so their survival depends on having a healthy level of working capital.

But let's say your business is doing well, and you're ready to buy an important piece of equipment, expand your store or open a new location. Remember, the money to fund this expansion can come from only three places: cash from owner and retained profits (equity), and debt.

If you don't have enough equity in your business, the only way to pay for expansion is to borrow the money. While it makes sense for most businesses to carry some debt, if that debt level gets too high-in excess of $2 in debt for each dollar in assets-it can lead to a few problems.

Your interest costs spike, which eats into your profits. Worse yet, you increase the risk of running out of cash.

If your expansion doesn't bring in enough new business, or if sales slip for any reason, you might have a hard time repaying the bank within the terms of the loan.

So the more equity you have in the business, the less you have to rely on borrowing for expansion.

A good rule of thumb is that your business can do annual sales of about five to 10 times your equity level.

When you exceed this level, the only way to support your additional sales is with borrowing, also known as financial leverage.

This borrowing can take several forms-bank debt, stockholder debt, extended terms from your suppliers, letting some of your accounts payable slip into overdue status or any combination of the aforementioned.

Whatever form your financial leverage takes, you're increasing the risk of running your business. The risk is that if sales slacken, even for a short while, you might find yourself in a liquidity crunch, struggling to find the cash to pay your bills and continue operating.

Finally, let's say you want to have the option of selling your business someday. Your business' profitability track record will have a huge impact on the sales price you receive. The higher your retained profits-which in turn boosts your equity-the higher price you'll command.

Keep in mind an exit strategy should be planned with profitability and retained earnings in mind to increase the value of your company.

Plus, your equity level, compared with your debt level, in effect tells you how much of the business belongs to the owners vs. how much is promised to the people from whom you have borrowed.

When you sell your business, you'll have to pay your creditors with the proceeds. So the higher your proportion of equity vs. debt (known as a low debt-to-equity ratio), the more you get to keep of your sales price.

There's nothing wrong with trying to lower your tax bill, but in seeking to do so, don't neglect building equity in your business. Especially in tough times, equity is a critically important source of funding for tire retailers.

Jack Phillips is vice president, credit and financial services, for American Tire Distributors Inc. in Charlotte, N.C.

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