The Fight Over Capital Assets
Yes, I am making another video on capital assets, because this is something they don’t tell you about in business school. Stakeholder’s in business often fight over capital assets. I am going to explain what this conflict is all about. Watch now!
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VIDEO SUMMARY
I want you to imagine something. Imagine you are running a business, and you have two groups of stakeholders. One group thinks it is a good thing for you to have as many capital assets as possible. The other group thinks you should have as little capital assets as possible. Your job is to keep both these groups of people happy. Does that sound impossible? It is, and that is exactly what you have to do in business. You have debt holders and equity holders, who have competing interests when it comes to capital assets.
Let us look at the balance sheet and I will explain to you what is happening. You have Assets, Liabilities and Owner’s Equity. This is based on the famous equation we all know: Assets = Liabilities + Owner’s Equity. The Assets represent everything the business owns. The balance sheet describes how the assets are split up between these two groups of stakeholders: Debt holders and Owners.
Liabilities represent the debt the business owes to other people. An example of this is when a company takes out a loan to buy a capital asset. The capital asset goes under assets, and the loan goes under liabilities.
Owner’s Equity represent the owner’s investment in a business. If an owner funds the purchase of the capital asset, the capital asset goes under assets, and the claim against that asset is recorded as Owner’s Equity.
These two groups of stakeholders have different interests that often compete. The biggest distinction is priority in bankruptcy. Bankruptcy is the worst case scenario for a business where it shuts down. In that situation, the business would sell all of its assets, and distribute the cash first to the debt holders, and then whatever is left would go to the owners. The debt holders get priority treatment.
Think about what this means. If you are a debt holder, you want that company to hold as many capital assets as possible, because it reduces the risk they will default on your debt. If you are holding the debt for one factory building, and you know that business owns five factory buildings, there is a good likelihood the business will be able to pay off your debt. If something horrible happened to the business, by the time they sold off all five factory buildings they would hopefully have the money to pay you back for your debt. This is the reason why debt holders care about the debt to total assets ratio.
Quick tip: What is a debt to total assets ratio? This ratio compares whether assets can cover liabilities. This is used by long-term creditors to determine a business’ ability to cover their debt. The more assets, the less risky the debt repayment, and the better for the person holding the debt. These ratios are often written into bank loans, requiring businesses to keep above a certain level of debt to assets.
That was a lot about the debt holders. What makes the owner’s different? The owner’s actually want less capital assets, because the owner’s care more about a different ratio: Return on Assets (ROA).
Quick tip: What is the Return on Assets ratio? This ratio compares net income over total assets. If you can generate greater amounts of income from smaller amounts of assets, that means you are more efficient.
ROA is a n important equation for owners for a simple reason. Better ROA means it is easier to grow and scale the business. If you reduce your capital assets, that increases your ROA. Investors are looking for the most effective use of their capital. For a business owner, if you wanted to duplicate your business in another city, it is easier to do that if you are able buy fewer assets.
This sets up a conflict between debt holders and owners. Debt holders want more capital assets. Owners want less capital assets. You as a business leader are stuck in the middle. You are trying to maintain a balance that keeps all your stakeholders happy in this impossible situation. This brings us one of the biggest questions in business: What is the ideal capital structure? What is the best ratio of liabilities to owner’s equity? There is no one right answer to this question. Every business is different. But the central issue of this question really is about keeping these two groups of stakeholders happy. Because the goal of business is to create value for everyone involved. So it is really important for a business leader to understand each of the different stakeholders and their interests.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.