The risk a small company carries on its balance sheet isn’t too hard to determine. A publicly traded company has its risk measured by a “beta” calculation. A publicly traded company with a beta of 1.5 means that the market price of the company stock will usually fluctuate at 1.5x the market fluctuation. The beta attributed could be the result of observed fluctuations (ie “technical factors”) as well as possibly the volatility of certain sectors to possible interest rate changes.

The “beta” of  a small privately held company is a “fundamental” factor. My own definition of beta is:   the ratio of outsider capital/insider capital where:

  • Outsider capital is: accounts payable and accruals plus statutory remittances plus term loans and mortgages
  • Insider capital is: shareholder loans plus shareholder equity.

This ratio shouldn’t be more than about 1.3:1; $1.30 in outside capital to $1.00 of inside capital. The higher the ratio (ie. the higher the beta) the greater the risks for the business. There are a number of risks that escalate given a high beta:

  • Business risk – the ability of the business to continue or get interest free funding.
  • Interest rate risk – as interest rates rise, credit limits become strictly enforced and banks tighten up on lending
  • Financial risk – the risk that the business may fail.
  • Foreign exchange risk – the risk to the business of currency fluctuations
  • Market specific risk – being a service industry in a one industry community.

It is easy to see that while outside capital may not change too much over a fiscal year, if the company incurs operating losses, the loss reduces the denominator and increases beta.

Beta is a real indicator of conditions that occur regularly in smaller companies. Any business operating “payroll-to-payroll” and stringing out creditors is over-extended and over-levered. A drop in revenue could cause the business to fail.

Many small businesses are severely under-capitalized.  Simply put – beta is at unacceptably high levels. Lenders look at balance sheets for this ratio. You should know what your “beta” is and have a strategy to reduce risks.

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