Both companies have a net income of $60,000 at the end of year one. However, Company A has zero debt, and only reinvests 50 percent of its net income back into the company, giving it a potentially manageable growth rate of 12 percent annually. Company B has 30 percent of its assets financed with debt and reinvests 100 percent of its net income back into the company, giving it a potential growth rate of 34 percent annually.

Figure 1. A comparison of the sales potential and net income for Company A and Company B. Company A has zero debt, and only reinvests 50 percent of its net income back into the company. Company B has 30 percent of its assets financed with debt and reinvests 100 percent of its net income back into the company.

After five years of reinvesting profits back into the company and the smart use of limited financial leverage (debt), Company B is earning an additional $156,259

in annual net income. This number would increase substantially, assuming continued growth. If the owner of Company B were to begin taking out 50 percent of the net income after the sixth year, that person would take home $130,000. This total is 2.5 times more than the $52,870 that would correspond to the owner of Company A (not including salaries). Granted, the owner of Company A has been able to accumulate more total dividend income than the owner of Company B, but let's take a look at what happened to sales.

After year six, Company A's sales would equal $1,762,342. Company B's sales would equal $4,320,400, based on manageable growth potential. If both companies were sold at the end of the sixth year, which company would sell for a higher amount?

The average valuation for HVAC contracting companies is 32 percent of net sales, according to Inc. magazine (July 2003).

Under this guideline, Company A would have a potential selling price of $564,000. Company B would have a potential selling price of $1,382,500. After subtracting for Company B's debt, the owner of Company B would take home $500,000 more than the owner of Company A. That is the power of compounded reinvestment.

A business owner may choose not to grow his business at the point where reinvestment in the business would not achieve a return on investment that equals or exceeds the company's costs of financing and/or the return available in other businesses with equal or less risk. At this point the owner may choose to take a larger salary, reducing profits and limiting company growth. The owner may even decide to sell the company.

Next week: In the final installment of the series, Roberts discusses ways to create value in your business.

Roberts is owner of Roberts Commercial Lending Co. LLC. He provides corporate finance and debt consulting, business loans, and leasing services. He can be reached at 586-716-8329 or CommercialFnnc@aol.com.

Publication date: 04/19/2004