Is a new investment by finance justified? : QA in business administration “Judge your profit growth by PL”

This time, Inamori* spoke about the above motto in his book : Practical Accounting -Business Administration and Accounting -.

What Inamori said is quoted with “”.

“Question: For our business, the logistics of industrial materials, when a major client moves their factory, how can we justify our new investment, which means the acquisition of lands close to them by arranging the finance?”

“Answer: If your profit remains above 10% and keeps growing, you can justify that new investment by arranging finance. “

Here, Mr. Inamori talks about the criteria to justify the new investment by increasing debt.

Let me explain one by one.

1. Analyze profit by department basis

“First of all, since you have two businesses, the logistics and processing, the performance of each one needs to be thoroughly analyzed in detail: depreciation, labor costs, interests, and their impact on the profit and loss of your company. In other words, if you build a new facility, you must consider the impact of the depreciation to the profit. But the land acquisition never occurs with such depreciation impact and you must only consider the interest and amortization of debt to be paid. Looking at operating profits of your company, although interest rates and depreciation have increased, the operating profit has increased from around 4% to nearly 10%. You are now a bit cautious on the further business expansion by arranging finance. I think you must simulate whether or not the business profit could keep around 10% , or keeps growing for next years.”

→ Our two major businesses are appraisal and brokerage. Although we currently have a limited number of people, we capture, calculate and allocate expenses for each department and project base. We need to make those allocations more precise so that we can timely and accurately capture the profit margin for each project.

2. Simulate the impact of interest rate increase

“However, although interest rates are currently very low, due to the economic conditions, it is highly likely that interest rates will rise and cause another burden to your company. Specifically, you must simulate in detail:  If the interest rate goes up by 1%, how much your profit would fall. You must figure out monthly the threshold at which you start making a loss. Then you discuss with your management team to share those turning points.”

→In the real estate, financial leverage is one of the important drivers to promote investments. However, I think we must be very much careful about loan to value ratio and never suggest finance over the property value. We must share this view with our clients to make them successful in investment, as we have a lot of lessons learned from the past bubble periods of the 80’s, before Lehman clash, and recent bubbles.

3. Accelerate the amortization of the debt

“However, I have always been very uncomfortable in expanding our business only relying on debt finance. I have been keen on paying back all the debts as soon as possible, since one of my mottoes says Wrestle in the center of the ring. We have been striving ourselves so harsh and finally we become no debt financial status, that has allowed us to expand our businesses with no debt.”

→When I was working for a bank, I used to appraise values of real estate which our bank considered as collateral. At that time, we considered various risks and made conservative assessments. Under the bullish market, people never put importance on such conservative attitudes. As we can learn from nature, something extreme needs to be adjusted to the moderate position over the middle to long term. To maintain stable management over the long term, it is crucial to have such a conservative attitude to reduce debts as quickly as possible.

Further queries or doubts, please email to ytomizuka@abrilsjp.com

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