In these very challenging and uncertain times many businesses see their sales and profitability fluctuating dramatically. They see their customers delaying purchases or reducing the size of these purchases. They may also find that their ability to get financing has diminished. It is in these times that the need for sound financial management is even more important.
When it comes to financial management, many companies focus solely on sales and profitability. This is a good start, but does not comprehend the entire picture, especially as businesses mature from an internally funded startup to externally funded business. As businesses grow in size, take on more employees, purchase fixed assets, engage in long term contracts and take on larger customers they need to be thinking not only about revenues and profits, but also assets, liabilities, equity and cash flow. They need to be thinking about how their decisions are going to impact the company’s monthly cash flow; both short term and long term. They also need to be thinking about how these same decisions will impact the company’s financial position or balance sheet. Are these decisions increasing or decreasing business risk? Are they improving financial strength or worsening it?
To borrow a term from my flight training, knowing your runway length is very important to a pilot. Pilots must know if they have adequate runway length to take-off or land their planes to ensure a successful flight. The longer the runway the more time the pilot has to implement: decisions, course corrections, emergency procedures, and survive. Applying this concept to businesses we look at a company’s monthly burn rate or expenses and compare that to how much cash or liquid assets they have in the bank. Dividing the cash by the monthly burn rate allows a business to understand how many months it can survive without sales or how long its runway is. The longer the runway or the stronger the businesses balance sheet, the more time a business has to be successful. Determining how long your runway should be will depend on your industry and your risk tolerance. It is also impacted by how quickly your company can change directions to adapt to its changing market. However, a good rule of thumb is to maintain a runway of between 12 and 24 months.
In many businesses, especially growing businesses, maintaining a strong balance sheet and adequate working capital is a challenge. However, with a good financial plan and sound financial controls a business can achieve a lot more success in this area. Having adequate working capital allows a business to have enough cash on hand to pay its short term liabilities such as: materials, payroll, rent and utilities. It also allows a business to continue to expand and do business with more customers and vendors. Conversely, a business that does not have a strong balance sheet and adequate working capital to pay its short term debt can find itself: cutoff by suppliers, losing employees, getting locked out of its office, just to name a few. Inadequate working capital can make it very difficult to operate on an ongoing basis.
Having a strong balance sheet enables a business to make decisions proactively instead of reactively. It gives the business more time to think through a decision and select an option that is in its best long term interest. Even though that decision may have a negative impact on the company’s cash position in the short term. It also allows a business to avoid unproductive time of managing dissatisfied vendors and customers that are not getting paid or paying on time.
From a banking perspective; having a strong balance sheet lowers risk. It can give the bank the assurance they need to write a business a loan, extend a line of credit, or provide it with other banking services. It also helps to ensure that the business will maintain the financial ratios required by its loan covenants. Adhering to loan covenants allows a business to remain in good standing with its lending institution and avoid having its notes or lines of credit reduced or cancelled. It also helps demonstrate to the bank that the business owner is in control of its business and has the ability to make principal and interest payments on any loan or line of credit. It also may allow the bank to provide the business with its most cost effective financing.
As most finance professionals know, “cash is king”. Having adequate cash in the bank and a long runway allows a company to sustain itself in a downturn or recession. It allows this business to be one of those left standing at the end of the day. It also allows a company to maintain its course when its competitors have to change theirs. It may allow you to: continue to market, hold on to top talent, retain key assets and avoid selling off assets at fire-sale prices. It also makes your business more attractive to those candidates seeking employment security. In many cases, having adequate cash in a downturn allows a business to potentially take advantage of its competitor’s weaknesses by: buying their business at deeply discounted prices, obtaining their customers, or buying their assets.
Not There Yet?
If you are one of those businesses that reads this letter and says, “…interesting information, but I don’t have a strong balance sheet”, then you could benefit from a plan to get you there.
It starts with research to determine what a strong balance sheet looks like for your industry.
What are those industry ratios for profitability, liquidity and solvency? What is ‘best in class’ for your industry? What will the ratios be in the future?
Use this information to establish your goals and then build a plan to get your business there over the next few years. Monitor your performance toward these goals each month to make sure you are staying on-track. Ensure that you understand the balance sheet impact of every major business decision before it is made. If you maintain focus and achieve these balance sheet goals, you will be building a stronger, more stable, more valuable business each year. You will also be building a business that is able to get the capital it needs to sustain long term growth.
Having a strong balance sheet can really make a difference with your business! It can give you the time you need to make good business decisions as well as give you the liquidity you need to operate your business on an ongoing basis. It can improve your position with your financial institution so that you get the capital you need to grow and help ensure your survival in an economic downturn. If you’re not there yet, that’s Ok, but make a plan to get there! In the end, you will have a stronger, more stable, and more valuable business!
If you have any questions regarding the financial issues discussed above or any other financial issues, please give us a call at (480) 980-3977.
Note: The information contained in this material represents a general overview of finance and should not be relied upon without an independent, professional analysis of how any of these provisions apply to a specific situation.