In order to discuss the interest tax shield and write-offs we should first take a look at purchasing
decisions. Purchasing decisions are very important to the well being of the business. Ill-thought out decisions waste resource and have negative impacts on the business.
Smaller purchases are less impactful, but many small purchases can add up quickly. Large purchases that don’t quite work the way you need them to or not at all have an affect that includes more than just the money spent. It can include losses experienced from learning curves, loss in productivity, business process reengineering costs, and opportunity costs. For a local small business, this can result in tens of thousands of dollars in wasted resources. For big corporate, it can result in millions, which is why they have teams dedicated to purchasing and will typically hire consultants to ensure proper implementation of more complex purchases.
Large purchases made by small business are generally garnered through the use of credit. (We will discuss using credit for purchasing deeper in the next post) Sometimes we can be over optimistic about the “if we buy it/build it they will come” mentality and we fail to perform the necessary steps to ensure the purchase is a good one. Good purchasers perform intensive research into products and their comparables generating a list of advantages and disadvantages among the top contenders. Then they look for product reviews and call on references to get real-world information. Once a decision is made on which product is the best fit, they perform a cost-benefit analysis. This analysis is then compared to all of the other necessary purchases the business needs to see which one is most important and which one can get the business the biggest bang for their buck.
Let’s see this in action and use a bakery for an example. The bakery is at capacity with production and they can either buy a new oven to increase capacity or they can marginally increase their prices, which should decrease demand. Which of these sounds better to you?
If you buy the oven, you risk a large capital expenditure, which will decrease monthly cash flow, but you have the potential to offset it and gain more profits by selling more product. However, there is no guarantee that you can sell enough to run the new oven at capacity and therefore maximize profits.
If you marginally increase the price, you will make more money on every item you sell, but you can lose customers that you may never be able to get back. The question here will be if you can capture enough revenues to offset the loss in demand. This is a very tough decision and cost-benefit analyses are never cut and dry, but you must put a value to everything. Be conservative, but as accurate as possible. A consequences table can aid in this sort of decision-making process.
Now that we’ve covered purchasing decisions, let’s take a look at the interest tax shield and its affect on the health of your business. Check back tomorrow for Part 2.