Focus On The Balance Sheet

Navigate This Recession With a Successful Financial Model
“Learn from the mistakes of others. You can't live long enough to make them all yourself” - Unknown

When it comes to mid market M&A, both business sellers and business buyers have traditionally focused in on the top line and the EBITDA. Sell-side M&A advisors have counseled their clients to focus on the P&L and do whatever they can to improve the revenues or EBITDA to get the most out of their business at exit. Similarly buy-side advisors have tended to counsel acquirers to look at the growth prospects of a target company instead of mundane things such as assets and liabilities.

The current recession and associated liquidity crisis are making business owners and advisors rethink the P&L focus. With deal flow down more than 50% in most sectors, liquidity being at a premium, multiples down across the board, and deals taking a long time to close, it is becoming increasingly clear that the P&L focus is no longer a proper approach for most businesses - especially for growth companies.

Assets and liabilities may not sound as exciting as revenues and earnings but now is the time for business owners to increase their focus on the balance sheet. Balance sheet focus can provide an early warning system and help the business owners identify the company’s shortcomings and improve the company’s health and help the company survive or thrive as we exit out of this recession. Without the focus on the balance sheet, it is easy for a company to find itself in a position where the company is under-using or misusing its assets or, worse yet, in an over leveraged position. Once a company finds itself in these situations, balance sheet repair can be a time consuming process. If a liquidity crisis develops for the company with a weak balance sheet, there may not always be sufficient time to pull itself out of an impending crisis.

To analyze the balance sheet for liquidity and performance issues, one needs to focus on four key areas: current assets, non-current assets, current liabilities and long term liabilities.

Current assets

Current assets are the assets that are likely to be used up or converted into cash within one business cycle. Typically these include: cash, liquid investments, inventories and accounts receivables. The main aim of analyzing current assets should be to find ways to strengthen the cash position and bring down the level of inventories and accounts receivable to a sensible level.

Even in relatively well run companies, it is common for a company to have stale inventory or have inventory that is significantly overstated or understated. A thorough evaluation of inventory should include ensuring accuracy of inventory, converting stale inventory into cash, and putting in place a process to keep the inventory levels current and lean. A company needs to ensure that its inventory turnover (cost of goods sold divided by average inventory) is high and the company is quickly moving product through the company at a rate better than its competitors. The analysis of inventory should also take into consideration how the inventory levels have been changing historically compared to its sales. Barring special circumstances, it is a sign of poor inventory management if the inventory is growing faster than sales.

Analyze the accounts receivables to understand how quickly the company is collecting on the customer accounts to ensure that its collection methods are not unduly lax and are competitive with the rest of the industry. If a company's collection period is higher than industry norms then the company may be accumulating subpar customers and/or leaving money on the table by letting customers stretch their credit beyond what would be considered a good business practice. Either of these conditions, even if intentional, may be unsuitable for the current economic climate.

Non-current assets

Non-current assets are all assets the company possesses that are not current assets. The balance sheet is typically deficient in accurately reflecting the value of non-current assets. Most assets that fall into this category have speculative values and may be of little use if there is a liquidity crunch. The analysis needs to identify ways of monetizing these assets if it makes economic sense or if it becomes necessary.

The analysis should include a spotlight on “off balance sheet” assets and hard-to-measure intangible assets and intellectual property items such as patents, trademarks, and copyrights. Special attention should be paid to non core brands and other items of goodwill that can fetch value if necessary.

Analysis of non-current assets should also be focused on ensuring that these assets are realistically valued. In addition to other benefits, valuing assets periodically may help the company write down asset values and reduce the tax bite and thus improve the company’s cash flow.

Current Liabilities

Current liabilities are obligations a company must pay within a business cycle. Typical items include payroll liabilities, payments to suppliers, and current portion of long term debt. Inability to pay current liabilities is the primary reason why many companies go bankrupt.

Analysis of current liabilities should include a thorough evaluation of how the company pays its suppliers, employees, and the government. It is necessary to clearly identify the company’s total short term obligations (including upcoming maintenance, capital purchases, current portion of long term debt, and any special or one-time payments to vendors, customers or government). Many a company has found itself in a cash crunch situation by failing to account for a liability that could have been easily forecasted with proper planning. Historical context is essential for predicting future liabilities. Having a historic context on how individual line items have varied over time with sales can also show if the company is overburdened with liabilities it does not need.

Analysis should also include an evaluation to determine if the proper form of financing is being utilized by the company for asset purchases. For example, is the company using short term debt to finance capital budget items?

Long term liabilities

Long term liabilities are non-current liabilities – i.e. the liabilities that the company owes in a year or more time. Long term liabilities typically consist of bank or bondholder debt. Sometimes “off-balance sheet” debt may have been used to finance capital expenditures while keeping the apparent debt levels low. Business owners must realize that carrying undisclosed debts can be dangerous in the current environment – especially if the resulting short term liabilities are not properly accounted for in cash flow calculations.

Summary:

In the midst of a recession and an unheard of credit crisis, even a moderately leveraged company may have difficulties raising capital. If the debt level is high by traditional standards, the company may be headed towards bankruptcy.

For a growth company looking to grow either organically or through acquisitions, being highly leveraged may mean that it may not find sources willing to provide debt financing. In this case, a company may find itself in a situation where it may have to issue stock on unfavorable terms. Worse yet, the company may find itself with a strong P&L but growing itself out of cash and into a bankruptcy.

Management should review its appetite for risk, the level of debt it wants to carry and whether it is using a proper mix of short term and long term financing and the overall degree to which a company is leveraged. A company that finances its assets with a high level of debt is risking bankruptcy. This may happen if the economy does not recover as expected or if the business does not perform as well as expected for other unrelated reasons. Business owners must comprehend worst case economic scenarios and ensure that they have sufficient resources to make debt payments.

A thorough focus on the balance sheet and a somewhat reduced focus on the P&L will help the company survive and thrive in the current environment.