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Squeezed Out

When it comes to the balance sheet, warns Laurie Owen, doing nothing is usually the worst possible decision.

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EVERYONE KNOWS KNOWS the value of a sponge: It absorbs water. Your company’s balance sheet is just like a sponge — except it soaks up cash instead of water. As a sponge nears its capacity, it becomes increasingly less absorbent. The same occurs with your balance sheet, and the phenomenon has two basic causes.

Furthermore, growth in sales is often accompanied by a decrease in the efficiency of operation. Increasing sales — or growth — create a need for additional money to finance an increased level of assets. The main source of this money for many companies is creditors — in other words, debt. Risk, in the form of higher debt, rises accordingly, and increasing interest expense may even put downward pressure on profits.

Furthermore, growth in sales is often accompanied by a decrease in the efficiency of operation. This inefficiency surfaces on the balance sheet, as proportionally more assets are required to support new sales levels. In other words, the rate of asset growth increases faster than sales; you make the same percent of profit — but you make it less efficiently.

So, what do you do? From my perspective, the clear message in a growth situation is straightforward. Manage better. I’ve listed below a few of the ways that can be done:

  • Manage current assets (inventory, A/R) more efficiently
  • Restructure debt (long-term, not short term)
  • Make more profit
  • Sell existing unproductive assets
  • Curtail expansion
  • Lease fixed assets
  • Implement sale-leaseback of existing fixed assets
  • Accept more risk (debt)
  • Don’t grow (use pricing to limit growth)
  • Get new equity — a passive investor or active partner

You need to arrive at the particular combination of components that will work for you. Remember, when it comes to the balance sheet, doing nothing is usually the worst possible decision.

By earning the same level of profits more efficiently, sufficient cash is squeezed out of the balance sheet to reduce significantly the borrowing requirements.

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Consequently, this concept that we’ve labeled the Financial Gap can be applied two ways. First, it’s effective as a tool to estimate borrowing needs in a growth situation — at an existing level of asset management efficiency. More important, it’s an invaluable management-planning tool for developing goals and standards of performance for efficient management. Keep in mind there are three fundamental parameters in evaluating the growth capabilities of expanding companies:

  1. How efficient the company is now
  2. The financial requirements of a particular company — what new assets will be needed
  3. The owner’s abilities as an asset manager

Growth is reflected on the profit and loss statement as increases in sales and (hopefully) profits. The cost of growth is generally reflected on the balance sheet in the form of increased debt to offset decreased efficiency.

These are controllable issues. If you choose not to control them, then your banker may choose to help. This help will come in the form of restrictive covenants regarding asset management — that is, turnover requirements for inventory and/or accounts receivable. (Listen for the comment: “I’m doing this for your own good!”)

What your banker is really saying is that borrowing implies a partnership; you supply efficient management and your banker will supply sufficient funds. Banks are in business to finance efficient growth — not to subsidize your inefficiency.

The sponge analogy? Well, efficiency translates to squeezing your balance sheet to free up the funds you need to grow; otherwise, you’ll find it squeezing you.

  • LUCKY NUMBERS
  • .85

What is it? Debt-to-worth. The debt-to-worth ratio for the top 25 percent in our 2005 FIT Jewelers Study showed that for every dollar owners have invested in the company, the creditors provided 85 cents. The median point for all participating companies shows that for every dollar owners have invested, the creditors invested $1.49. The Top 25 percent are less risky as measured by the debt-to-worth ratio. It’s calculated by dividing total debt by total equity.

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Strategy: Debt-to-worth is a favorite ratio for bankers, as it measures the potential risk of a company. (Rumor has it that some bankers can read your statements upside down from across the table and compute this number in their heads.) Unlike most other ratios, lower is better for this one.

  • MONEY MATH
  • Is Your Debt-To-Worth Too High For Your Banker’s Liking?

Here’s a formula for making the numbers work in your favor.

Some bankers will let you reclassify any money you have loaned to your company as equity. This is provided that you agree to be last in line when the loan needs to be repaid. Let’s say a company’s net worth is $1 million and its total liabilities are $3 million, putting its debt-to-worth ratio at 3 to 1. The banker says “no-go”; she can’t loan to companies with a ratio at or above 3. But if the liabilities include a $250,000 loan made to the company by the owner, you can reclassify it as equity. The company’s debt-to-worth drops to 2.2 ($2,750,000 ÷ $1,250,000). To improve this ratio,  in the longer term, generate more profit and pay down debt.

This story is from the January 2007 edition of INSTORE.

Laurie Owen was INSTORE's financial columnist during the first decade of the publication's history.

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