FRICTO analysis for financing assets
Regardless of the economy's health or electrical contractors’ profit margins, lost
assets must be replaced. There are several ways to obtain asset financing, such as
incurring more debt in the form of loans or issuing shares of stock to raise
capital from investors. Various frameworks are used to analyze the preferred method
of raising capital for a particular situation. Although the more sophisticated
frameworks are difficult for privately held firms to apply in the absence of a
market-driven stock price, the underlying factors are relevant to all financing
decisions.
One such framework is FRICTO, an acronym describing six steps used to analyze and
compare financing alternatives. I will summarize the six steps—flexibility, risk,
income, control, timing and other issues—in this two-part series as an example of
the decision-making structure supporting such financial decisions.
Every financing decision, regardless of industry of operations or company volume,
involves at least three considerations: how much money the firm needs, what
policies are in place that affect how the firm raises capital and the obligation of
the firm to pay dividends (if any) to stockholders.
Flexibility
Flexibility, in this analysis, means the ability to survive a rare, unpredictable
event that could threaten the future of a company. Examples of such events are the
Great Depression or a serious liability claim. You would expect to weather such a
crisis using a combination of insurance coverage and short-term debt, such as lines
of credit (as well as cash reserves) to continue operations until the danger has
passed.
When interest rates are low, or the economy is good, managers often overlook the
need to keep some debt capacity available and borrow the maximum available funds.
Under some market conditions, even the most creditworthy are unable to find
financing if all available funds have been absorbed by other borrowers.
Risk
In contrast, you are expected to meet anticipated business downturns with short-
term funding, such as cash reserves or working capital (current assets – current
liabilities from your most recent balance sheet). Short-term debt, such as lines of
credit, should be maintained to weather these events, as well. You would defer
large capital investments until the cycle has shifted to a market upturn.
The point is to have available reserves to meet these predicted short-term cycles
and not to overextend your contractual obligations (ability to pay interest on
debt). A coverage ratio (such as operating cash flow divided by interest payments
on debt) helps you measure your status in this area. Dividend obligations and tax
rates often are combined with the interest-payments figure, and the ratio becomes
smaller as you take on additional debt, inflating the interest-payments figure.
Income
This step relates to impacts on stock value and dividend payments. The relevant
terms are explicit costs, dilution of earnings per share (EPS) and implicit costs,
which are calculated for each financing alternative. Explicit costs include the
cost of debt (annual interest payments divided by net proceeds from stock issues or
loans after fees are deducted) and cost of equity (earnings per share after
financing divided by current stock price).
Dilution of stock price is projected for financing alternatives by comparing the
earnings before interest and taxes (EBIT) for each. For private firms without a
stock price determined by the open market, this is difficult to calculate, but the
main idea is that issuing more shares will dilute the value of existing shares. So,
unless you can pay additional dividends from higher profits, which you hopefully
will earn with the assets you are financing, current shareholders will be
displeased. If you raise money by taking on additional debt, your interest payments
will be deductible, reducing your tax burden and perhaps allowing you to raise
dividend payments. There is a point at which the dilution of stock value breaks
even or is the same using either stock or debt financing.
Implicit cost is related to the perception of the marketplace as to how much
additional risk you are taking by incurring additional funding. Again, it is
difficult to measure this for a privately held firm, although you might look at
publicly traded electrical contracting firms and try to get a sense of when they
have crossed the line.
So, if you are not a large, publicly traded electrical contracting firm, why should
you be interested in a FRICTO analysis framework? It’s complicated, and without
being able to calculate earnings per share, it may not appear applicable to your
company. Nevertheless, the awareness of the factors affecting each of the
calculations is critical to your own ability to analyze financing alternatives,
even if you are a small firm. Next month we will look at the other three steps of
FRICTO, to complete the analysis framework and apply the remaining concepts to
privately held and publicly traded electrical contracting firms.
