Profits On Purpose | Teaching Financial Statements to Drive Performance: Part 1 The Balance Sheet
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Teaching Financial Statements to Drive Performance: Part 1 The Balance Sheet

We believe it’s critical for every business owner to know how to manage money once it’s in the business rather than just making sales. And it can be even more impactful if all employees are empowered to know how the decisions they make affect the bottom line and top line of the business. In order to drive performance in your organization, you should have priorities based on the metrics you measure for your business. Those metrics are typically in the areas of profitability, asset quality, liquidity and leverage. (PALL)

I have a client who had a breakout year last year. Accounts receivable doubled, cash declined about 20%, debt increased by $300,000 and equity increased by over $375,000 from profits. It’s fairly easy to look at the balance sheet and determine what went up or down, but the more important question is why and is it a positive trend or negative trend?

First, the balance sheet is more important than the income statement. Three of the four things in PALL (asset quality, liquidity and leverage) are reflected on the balance sheet.

Asset quality:

  • Receivables can go up due to increased revenue or a slow down in collections or a combination.
  • It can also be you have some AR on the books that needs to be written off.
  • The best metric to use to calculate asset quality in AR is the AR turnover ratio. Take your annual revenue/ AR at year-end and you will come up with a number probably between 6 and 12. The higher the number, the faster you’re collecting.
  • To come up with the numbers of day’s sales you have in AR take the number, 8 for example, and divide in to 365 days in a year. You will come up with 45 days sale in AR. (365/8=45 days in AR).
  • When you have revenue growth, but your AR turn stays consistent year to year, the increase in AR is attributable to sales growth, if your turn changes (better or worse) it’s due to changes in your collections.

Liquidity:

  • Most business owners measure liquidity in how much cash they have in the bank. Some measure it in working capital (current assets – current liabilities).
  • You’ve likely heard the expression “cash is king.” So, most business owners look at bank balance as a measure of their liquidity.
  • In my example above, the company I mentioned had significant sales growth last year. Growth always requires cash, so if you’re a growing company, cash will always be at premium.
  • You can increase cash by retaining profits, collecting your AR a little faster, paying your trade a little slower, borrowing from a bank or putting money in yourself.
  • The metric most business owners look at is the number of day’s sales in cash. Take your annual revenue and divide by 365 and that will give your daily sales. Then take that number and divide it in to your cash balance. For example, if you have $20,000 in sales per day and you have $140,000 cash in the bank, you have 7 days of sales in cash.
  • I’ve seen companies with as little as 3-5 days sales in cash and as high as 30 days.

Leverage:

  • With a growing company, to finance your asset growth how much of your own money did you use (net worth or equity) vs. how much of your creditors money did you use (payables and bank loans)?
  • In my client example above, the company had asset growth of almost $700,000.
  • To finance that they borrowed about $320,000 from lenders and financed the remainder with profits. This company needs to have a few more good years of profit retention to reduce their leverage.
  • The best metric business owners use is the leverage ratio. You take the total debt/total equity to come up with the number. If you have $1.5 million in debt and $500,000 in net worth, your leverage ratio is 3-1. Said another way, you’ve used $3 of debt and $1 of equity to finance your assets.
  • Most banks are comfortable loaning up to about 3-1 leverage, some up to 4-1. Much higher than that and they will refer you to an asset based lender to borrow against your receivables.
  • This is a collateral based loan with a much higher interest rate because of the leverage.   Since you have all the upside in your business, the less leverage (more skin in the game you have), the less perceived risk in loaning to your company from the lender’s point of view.

Depending on what you want to improve on your balance sheet, you will implement a strategy or process to address those issues. Then you will direct your co-workers to focus on specific execution with a goal of improving one or several of these metrics.   If you have questions, please feel free to ask a question by hitting the contact button at the top of the page.

Bill McDermott
bmcdermott@mcdfs.com
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