The Value Equation. Christopher H. Volk

Inventory levels are low because the inventory tends to be sold every three days or so. Meanwhile, the trade payables from food vendors might come with 30-day terms, meaning that you could literally sell your inventory 10 times over before ever paying for the first inventory you had.

Accountants vs. Entrepreneurs

If you think in accounting terms, you probably think of business investment as the “left side” of a balance sheet, which is where the assets are. I do not view business investment in this light. I am a finance person, which is the foundation for accounting, but one step removed.

      Finance is like music; it is a universal language, whereas accounting is not.

      There exist multiple global accounting standards, which are subject to frequent changes. The dominant standards are US Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), which is used by much of the rest of the world. With that said, GAAP is widely used globally among larger companies owing to its requirement for a US stock exchange listing. Accounting was devised to represent financial reality to investors and financial statement readers. However, the reflection will always have material imperfections. This is why there are so many analysts who make a living from interpreting financial statements. This is why financially inclined value investors pore over financial statements to see what the markets cannot.

      From a finance perspective, total assets as they appear on a corporate financial statement do not equal business investment. To arrive at business investment, a financial analyst must ignore all the non-cash accounting conventions. This means that items like “accumulated depreciation,” which is designed to illustrate the cumulative “wear and tear costs” of a business on its hard assets, need to be added back. It's not that assets don't have wear and tear; they do. It's that the wear and tear does nothing to alter what the assets originally cost. Wear and tear does not alter the business investment. Since the accounting profession has added numerous non-cash financial reporting conventions over the years, you can be busy eliminating balance sheet items.

      The somewhat shameful fact is this: If you are looking at a corporate financial statement and actually trying to understand business investment, the number is nowhere reported. Our accounting profession has wrongfully determined that it is unimportant to keep track of what assets originally cost.

The next chapter will discuss the “right side” of the accounting balance sheet, which discloses liabilities and shareholder equity. But as a finance professional, some of the liabilities must be netted against cash assets at cost to arrive at business investment. Those liabilities are the ones having no cost and no claim on the assets of a business. Normally, there are two such liabilities: accounts payable and accruals. We have already briefly discussed the first of these, which represents trade vendors who are willing to give you clear title to their merchandise and then wait a period for payment. The second of these represents the timing gap between a service being provided and payment for that service. The most major example of this is employee wages; employees come to work and then generally must wait two weeks for their paycheck. There might be other unsecured, non-interest-paying cash obligations, such as customer deposits, which would be shown on the financial statement as a deferred income liability.

Variable #1: Business Investment

      Number 1 of the Six Variables is business investment. To determine it, simply net accounts payable, accruals, and other unsecured, non-interest-paying cash obligations against the cash assets at cost. A short version of the business investment variable is shown below. Later on, I will expand this important variable to show its components.

While the accounting profession may have difficulty determining what business investment is, entrepreneurs generally can zero in on the number. One thing they know is that a lower business investment is better than a higher investment because it requires less funding. Certainly, the growth in global supply chain technology sophistication has played a role in the rise of “asset light” as a business term. If you can have less inventory, have extended trade credit terms, outsource your manufacturing, and then sell your product with fast payment terms, your required business investment can be substantially reduced. Had Daymond John been more “asset light” at the outset, his business investment requirement would have fallen materially, his liquidity would have substantially risen, and his risk of business failure reduced. As I learned a long time ago when I started out in banking, “Companies do not go out of business because they lose money. They go out of business because they run out of cash.”

Note

      1 1. J.D. Harrison, “When We Were Small: FUBU,” Washington Post, October 7, 2014.

Chapter 3 The Capital Stack and Two More Variables

      Devising how to fund your business investment typically involves multiple capital sources. Those capital sources are mostly evident from the right side (or so it's always called) of the financial statement balance sheet, which is where liabilities and shareholder equity are reported. In finance vernacular, the various sources of capital used to finance business investment are often referred to as the “capital stack.” In the case of Daymond John, his capital stack was simple: He personally borrowed $120,000 on a second mortgage loan on his home and then infused that cash into his company as an equity investment. Typically, capital stacks are far more intricate.

The Right Side

I have found that most investors and entrepreneurs spend far more time focusing on the left side of the balance sheet than the right. In the case of STORE Capital, the most recent company where I served as founding chief executive officer, the left side of the balance sheet was loaded with profit-center real estate assets the company owned and leased on a long-term basis to service, retail, and manufacturing companies across the country. Most of the questions I fielded from investors and analysts stemmed from these investments.

      When it comes to evaluating the right side of real estate company balance sheets, many corporate observers are simply inexperienced. For one thing, most public real estate companies have similar sorts of borrowing, with the resultant interpretation that the right side of a balance sheet is less important. However, this is far from so.

      In 2005, at a predecessor public company, we conceived of a novel way to use serially issued secured debt. About three years after we embarked on this process, we sold the company to an investor group that was able to fully assume the highly flexible debt we had created. The result was that our shareholders were able to realize a compound annual rate of return approximating 19%, which would not have been possible without the flexible, assumable nature of our debt obligations. Had we simply followed the well-worn path of traditional financing options employed by most other industry participants, we and our shareholders would have missed out on this opportunity.

      Borrowing sources can be instrumental in elevating shareholder rates of return, improving corporate flexibility, and even protecting shareholders in the event of severe economic turbulence.

Other People's Money (OPM)

When conceiving a corporate capital stack, there is an order of operations. At a high level, your analysis should begin with how much you can borrow, and then back into how much equity investment you might need. In the example of FUBU, Daymond John had no access to corporate borrowings when he founded the company. So, he made a $120,000 equity investment into FUBU that was funded by a personal loan he had to collateralize with his home. That small, but meaningful, investment ended up generating over $6 billion in revenues, ultimately making Daymond John an amazing financial success story. Over my years in business, I have seen similar