Sunday, April 28, 2013

Don't Believe Everything You Read

It’s an interesting phenomenon that the average daily page-view statistics for this blog have increased since I stopped writing on a regular basis.

It’s instructive to watch the activity and to see which topics are drawing most attention as time passes.

The two general areas of discussion that seem to be of greatest interest are:

a) the size of the potential market, and

b) the assessment of risk.

So I’m going to come out of retirement to make a few points that I would want to make to anyone reading what I’ve written in the past.

(Caution: This won't be the only post-retirement post!)

First, I need to acknowledge an error in logic and analysis that anyone reading my prior analyses of potential market size should consider.

In the posts I wrote regarding potential market size I used data sources that could be verified and methods of analysis that I considered sound. However, I missed a step in the analysis that was critical and that I would caution others not to miss.

That step is an assessment of the ability of a business to pay for the liquidity it needs.

The potential size of the market for TRE, or for any other invoice-factoring entity, must be constrained by a reasonable assessment of the ability to pay.

If a business or an industry tends to operate on a pre-financing margin of 15% of revenue, for example, and it needs outside financing of about 75% of its costs; then it needs financing of about (85% x 75% = ) 64% of revenue. If it has to pay an annualized 25% all-in cost for the funds needed, the cost of financing essentially absorbs its entire margin.

Now, I know that’s a little simplistic and I know the arguments in favor of the spot-factoring solution. I’ve made them myself and they are perfectly valid in many cases, but usually in the short-run.

In order for such a solution to be viable on a long-term basis, the cost of the money has to bear a reasonable relationship to the margin generated by the business being funded. And when margins are being squeezed and money is most commonly needed, the price of the money rises; it does not fall.

The business owner can make short term adjustments and defer other expenses for a while. But he cannot do that forever.

Either the price of money changes, or the business changes its pricing model or its cost structure. But if those avenues aren’t available, the business owner is in an untenable position.

So, the two questions that have to be asked and answered in getting to a final number on potential market size are:

What is the anticipated all-in cost of the financing solution under study? and

What portion of the defined market segment can actually afford to pay that price for liquidity?

All else equal, the higher the cost of money (including exchange fees in the case of TRE) the smaller the size of the potential market.

And, the higher the margin commanded by a particular business or type of business, the less likely it is that it will need financing on an ongoing basis.

The textbooks tell us that the higher the risk, the higher the required return.

In this scenario, the higher the required return, the more likely that cost of money causes default.

So, what is the size of the potential market for TRE?

The answer has to be multiply-determined, with cost of funds and ability to pay among the determinants.

Whatever the number is, it should increase as cost declines.

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