Equity Buffer is your answer

There is no such thing as a smooth life – and will always have ups and downs. It is good to have a glass of wine on a shiny day, to multiply our happiness; but more importantly, is to have a safety net prepared 24/7 to cushion your free fall on a bad day.

Equity buffer is exactly the cushion for a company to survive in a bad situation. After all, companies are all in a “hunger game” and who last survives is the winner. If you are looking for the ultimate one thing to carry with you – equity buffer is your answer.

What is equity buffer in finance?

Equity buffer is a fundamental concept for finance. As its name suggests, Equity buffer breaks into 2 parts – “equity” and “buffer”.The first part, equity, represents capital invested for growing more capital (Rewards). The second part, buffer, represents capital as an absorbent, buffering against losses (Risks).Equity buffer, therefore, encompasses the trade-off between minimizing risks and maximizing rewards. Furthermore, it explains the behavioral aspect of greed and fear.

Many of us may wonder: is equity buffer the same as the “shareholders’ equity, or tangible net worth, or total assets less total liabilities”? No. These are simply the precursors for equity buffer.

Always remember that the risk-reward relationship is changing in real-time as our world. So equity buffer is never just a number at a certain point of time – like those accounting terms above – but is dynamically changing all the time.

Outsiders to the company like us, including investors, bankers, etc. only get updates periodically like quarterly/annual report, and we are easily misled to think “statically“. That’s not true. We need to think in their shoes and it’s what the entrepreneurs see: “dynamically“.

To summarize, Equity buffer is dynamically adjusted from “shareholders’ equity or tangible net worth” in order to reflect the company’s real risk-reward proposition. 

Real-life example on equity buffer

An entrepreneur Ben starts a widget-making company with $100 cash as the initial equity. Is this amount sufficient? It depends on the risks of the business he planned. So how can the bank tell?

The story starts when Ben applies for a hire purchase financing of widget-making equipment necessary to build up the inventory. Assume the machine’s price may vary. Let’s see how the bank makes the decision, with EB firmly in view.

When the bank gets additional information on the company, they integrated and make forecasts in the following 6 different situations, to test how the company performs financially (and pay them back eventually).

Now Let’s make the forecast together with the banks.

For the forecast assumptions, #1 and #2 are when the business is growing perfectly as planned. Furthermore, #1 illustrate equity as the seed capital with its leverage, fuel the first growth; #2 is with additional financing, and fuels more growth and better ROE against a deteriorated D/E ratio.

#3 and #4 like #1 and #2, but is when the sales/revenues do not grow as planned – only sold half.

#5 and #6 is when the business suffered headwinds. For example, lots of companies suffered loss during COVID-19 happened in 2020. Assume this happened on top of #1 and #3.

The bank then synthesis the ratios on the following page.