A news correspondent once asked a Somali nomad how much his house cost. The nomad found the question slightly baffling. He explained that he had built it himself, with materials he had on hand. The walls were made of sticks, woven together and curved into a dome. For protection against rain and sandstorms, he had laid animal hides over the top and lashed them down. He could not say how much the dwelling was worth, because it would never have occurred to him to sell it. When he moved away in search of better pasture, he simply dismantled his house, loaded it onto a camel’s back and took it with him.
Hernando de Soto (De Soto), a famous Peruvian economist known for his work on the informal economy, defined dead capital as “an asset that cannot easily be bought, sold, valued or used as an investment”. De Soto’s work showed that even those who live in slums possess far more capital than anyone realizes. These possessions, however, are not represented in such a way as to make them fungible assets i.e. exchangeable assets. These assets therefore cannot create value for the owners thus they are ‘dead capital’.
De Soto in his book titled “The Mystery of Capital” revealed that most people in third world countries are not as impoverished as portrayed. He found out that the total value of untitled real estate (land) held by the poor of third world and former communist nations is at least US$9.3 trillion. Furthermore, De Soto estimated that the total value of Africans’ informally owned houses and farmland in 1997 was roughly US$1 trillion. These assets are not captured in any land registry known to the legal or financial system in those countries. They are only in possession but not legally recognized to be owned by them. Therefore, these peasants are unable to exercise transferable (ownership) interests and rights in these assets as financial capital in the form of collateral/guarantee for loans, secured assets (asset securitization) or as capital contribution to a partnership.
In the same way, SMEs in Nigeria invest a lot of capital in the form of factors of production (land, labour, financial and intellectual capital) into their business, however they still do not generate as much value (profits) as the capital invested. This is because the capital employed in the business is dead and has not been activated. Some SMEs are afraid to approach a financial institution for a loan because they are not even aware of the capital they possess that they can exchange as collateral for the loan. Some entrepreneurs are selling their business/companies for far less than it is worth because they are not aware that the value of a business is not only the cash in the bank and the business premises. Client list, business name, softwares, equipments and even employees are all capital of a business that has value and can be sold. On the other hand, how can you sell what you do not know exist?
Recently, the Acting President Yemi Osinbajo signed into law, the Secured Transactions in Movable Assets Act, 2017 (otherwise known as Collateral Registry Act). The Act ensures that Micro, Small and Medium Enterprises (MSMEs) in Nigeria can register their movable assets such as motor vehicle, equipments and accounts receivable in the National Collateral Registry and use same as collaterals for accessing loans. This, in turn, will increase their chances at accessing finance and thereby tackle one of the major obstacles faced by MSMEs. However, the question remains – how many SMEs are ready to tap into this potential? That is, how many SMEs have properly documented capital to register at the Registry?
In order to ensure that you are generating value from your capital, you must ensure that it is formally or legally represented and traceable to a functional institution, department or agency recognizable at law. Dead Capital is any form of capital without formal or legal representation. Capital is given life only when it is represented in writing by a recognised authority established by law.
Some practical ways of ensuring your capital is titled or formally represented to enable your business have access to incentives and financial capital include the following:
1. Business name registration with the Corporate Affairs Commission;
2. Software/Intellectual property/Patent registration with the Trademarks, Patents And Designs Registry, Federal Ministry Of Industry, Trade and Investment;
3. Product registration with the National Agency for Food and Drug Administration Control (NAFDAC) and Standard Organization of Nigeria (SON) for product imported into Nigeria;
4. Certificate of Occupancy or registered Deed of Assignment with the Land Registries in all States;
5. Motor vehicle registration with the Federal Roads Safety Commission;
6. Equipment registration (with value above NGN 500,000) with the Industrial Inspectorate Division of the Federal Ministry Of Industry, Trade and Investment;
7. Preparation of a statement of affairs such as cash flow, profit or loss and statement of financial position; and
8. Bank Verification Number
Remember as faith without works is dead so also capital without legal ownership is dead. Therefore, in order to create that confidence in investors to invest in your business and financial institutions to make credit available to you, you must bring to life every capital in your business no matter the size or type.
The year 2016 marked a season of inflation and scarcity for various commodities; tomatoes, pepper, imported rice and not forgetting the world’s most desirable currency, the USD dollar. The free fall of the exchange rate of the Naira to the dollar has been a sore point in the political discussions and an index, in tandem with price of PMS and electricity supply, for judging performance of the current Government. The enlightened populace has been waiting for the Central Bank of Nigeria’s pronouncement on how the new Foreign Exchange (FX) regime.
This article is simple to explain how companies and business owners can hedge against FX fluctuations which affect their businesses.
Hedging as defined by the Oxford Advanced Learner’s Dictionary means to protect yourself against losing money. Therefore, I will attempt to explain how hedging can be done by business owners due to the fluctuations in FX rate.
Sometimes last year,A few days back, I stopped by the roadside sales woman on my way home to buy a bunch of plantain. While still expressing shock at how costly this small bunch was, a neighbour of mine who met me there was regaling me with stories of how expensive tomato wasis and how a piece wasis more costly than an apple – I hadve seen that on twitter, then I remembered that my dear wife had hedged against this risk by buying a basket full of tomato’s months back at Mile 12 market and we don’t have to worry about tomato prices in the medium term – Good woman.
So what are the hedging tools we might see take centre stage in the Nigeria market.
Firstly, the Fisher effect
The International Fisher effect postulated by American economist Irving Fisher shows the relationship between interest rates, inflation rate and exchange rates. Basically, one can predict the future exchange rate of a country’s currency against a reference country currency. So let’s assume that the Naira currently goes for N200 to the $ and the year-on-year inflation for Nigeria and the USA is 10% and 5% respectively. The expected exchange rate for Nigeria at the end of Year 1 would be N209.5/$ (N200 x 110/105). This simple theory also has a relationship with the Interest Rate parity theory which states that expected future movement in Interest rates can also use be used as a basis for determining the future exchange rate at a forward date (assuming variables related to the reference currency remain static). Therefore if the current N/$ exchange rate is N200/$1 and Interest Rates are expected to rise from 10% to 15% in the next year, the future forward exchange rate would be N209.09/$1 (N200 x 115/110). However, we don’t live an ideal world and exchange rate movements are not as simplistic as this.
Now, Hedging Options
It’s June 30 2016 and Mr. Alao needs $100,000 to buy a tractor by December 31 to for use on his cocoa plantation by 1st January 2017. The current dollar buy rate is N200 and therefore Chief Agbabiaka would need N20,000,000 today to buy the tractor. However, he is concerned that using N20m would not be a wise option since he could invest this amount in treasury bills at 10% and just keep it in a fixed deposit account till he actually needs to sell it in December 2016. Worse still, he might not have the N20m to trade with at this time, what can he do?
1. FX Forward Contract
This is used when you want to hedge your foreign currency risk in a simple way up to a predetermined worst-case exchange rate. This is done by exchanging a sum of money into a different currency on a particular date (or within a particular timeframe) in the future at a predetermined exchange rate.
In this case, Mr. Alao goes to the Bank and enters into a forward contract to buy $’s from the Bank on December 2016 at a certain rate. The Forward Rate is agreed at the time the contract is entered into (June 30) and we assume this is N220/$1. It’s unlikely that the Bank would enter into an agreement at the current spot rate as the impact of Interest Rates and Inflation would imply a change in rates at a future date. Mr. Alao assess that this rate is fine and signs the deal. On 31 December, he goes to the Bank collects his $100k and parts with N22m – deal closed. If the rate in the market is now N240/$1, Chief has saved a cool N2m but if it’s the converse and rates are still at N200/$1, he’s lost N2m. However, he’s sure of his cash outlay well ahead of time and therefore reduces the risk of uncertainty in future exchange rates.
2. FX Options
Moving from the first scenario in No. 1, Mr. Alao can take advantage of an appreciation in exchange rate by entering into an Option agreement with the bank. So he says “Mr. Banker, I agreed to buy dollars from you in future at N220 but if it’s N210 in the market, I lose N1m”. So Mr. Banker says he can actually enter an agreement with the bank at a lower rate at the future date but would have to pay an option fee. So he agrees to pay N200K today for the risk the Bank will take on future appreciation in exchange rates. Therefore if the Naira depreciates to N210/$1 in the future, Mr. Alao’s outlay is N21,000,000 (N210 x $100k).
However, he has paid an option fee upfront so his total outlay is actually N21,200,000 which translates to an effective exchange rate of N212/$1. If the Naira/$1 exchange rate depreciates to N240/$1, he simply doesn’t exercise this option and goes ahead to buy at N220/$1 which makes his effective cash outlay as N22,200,000 and effective exchange rate as N222/$1.
An effective cash flow management through hedging can greatly reduce the probability of a company suffering from currency issues in the future.
Please note that the above analysis is done from the perspective of the business owner.
Start Smart Series – Part 2
Starting a business can be daunting but running the business successfully is the real deal. Running a successful small business starts with the planning stage of deciding what you will sell and where you will locate your business. However, it doesn’t stop there, as everything from your choice of employees to your accounting practices may influence your potential success. If you are smart, you will start right and start smart.
Starting smart begins with understanding “business essentials”, and a major aspect is accounting.
It is said that accounting is the language of business. It simply means that without accounting, no one truly knows what you are doing – even you too. The financial viability of your business is in doubt, business growth cannot be measured, and bankers don’t know if they can take the risk of providing credit to your business. This is aside from the fact that you will lack any probable basis for planning or making major decisions.
Accounting is the process of analyzing and reporting on the financial transactions of a person or an organization. It is therefore an important function of your business.
With a proper accounting system you are able to:
understand the financial health of your business
save money and reduce wastage
secure additional funding/bank loan in the future
make plans and achieve long-term goals
determine accurately how much tax to pay (without being ripped off by the man)
Small business accounting requires an entrepreneur to learn common accounting terminologies. Let’s take a look at the basic accounting reports that every business owner should prepare and review on a regular basis:
This is also known as the Profit or Loss (P/L) statement. It shows how much you made in revenue, how much you spent, and what your profit or loss is over a specific period of time. Are you making or losing money? Are you spending too much on an expense? The P/L statement will tell you.
This provides overview of your business financial health. It shows the worth of your business. That is, a summary of your business assets and liabilities. In simple English, it tells you what you own, what you owe and what is left over.
Cash flow statement
This captures how cash flows in and out of your business over a specific period of time. It captures cash flows in three categories: operations, financing and investing. Operations cash flow refers to money flows from normal business operations. Financing cash flows captures cash inflow and outflows from buying or paying off assets and liabilities the business uses for more than a year. While Investing cash flows captures capital inflows and outflows from investors (that is, from the entrepreneur, bankers, other funding parties)
If you desire to run a successful business, it would be beneficial to have an accounting system in place. This would ensure that you are accountable for the success of your business. It will also demonstrate that you are genuinely interested in growing your business. This will show that you are clearly ready for business!