Preface: “And just remember, every dollar we spend on outsourcing is spent on US goods or invested back in the US market. That’s accounting. – Arthur Laffer
What Is A Strong Balance Sheet?
Credit: Donald J. Sauder, CPA | CVA
A sage banker recently advised his client to have a strong balance sheet to prepare for the numerous developing shifts in regional and global marketplaces. Why? Because a business with a strong balance sheet is more likely to weather any overcast recessionary effects and be positioned to gain market share once fair-weather reemerges.
Most accountants will agree that assets = liabilities + equity. So the basic assumption of a strong balance sheet is to have more equity and fewer liabilities. Yet, there is much more to a strong balance sheet than equity.
As long a business can obtain a net profit for the year or quarter during a recessionary climate, the equity should hold fairly steady, albeit the business doesn’t require substantial distributions to finance owner personal obligations and investments (e.g., rental properties, funding for other debt such personal mortgage, taxes, or standard of living cash flows). Guarding against excess non-deductibles (owner draws, debt payments. etc.) helps insulate a balance sheet from atrophy.
Therefore, one of the primary considerations for a strong balance sheet is to analyze ongoing and recurring cashflow requirements for both business and personal obligations, e.g., non-deductible cash uses. What percent of business operating cashflows are available for financing activities, what allocations are discretionary, and what amounts are non-discretionary?
For instance, I recently heard a CPA talking about some quick analysis calculations for several clients to answer questions on appraising strong balance sheets with some back-of-the-envelope projections of what cashflows could look like if top-line sales ebbed 20% to 40% depending on the challenges expected with shifting economic winds in the marketplace.
In contrast, the worse thing a company can do is run out of money. Interestingly, based on increased interest costs, cashflow requirements for debt payments, and a caveat of higher taxes rates, it appears that some banks are willing to extend 20% or more in debt financing than can be comfortably managed in such trough scenarios by some borrowers, i.e., the companies could still be marginally profitable, and yet be in special assets situations in such scenarios, because their balance sheets are too unwieldy.
Another feature in analyzing a solid balance sheet is looking at working capital. Working capital is current assets – current liabilities. How much of your working capital is tied up in inventory, how much is cash, and what $ | % is allocable? Astute financial managers monitor working capital levels constantly and regularly prioritize optimization.
Experienced managers are proactive in balance sheet management and divest excess cash-intensive assets with low ROIs before they become a business detractor or decrease in value, e.g., surplus equipment, trucks, and vehicles. Business is not speculation. However, many business owners approach to inventory and asset management as such. It is best to remember that such speculative rewards are often simply a matter of time and chance. It’s like the Monopoly Chance card to pay for houses and hotels. It’s not a problem in the game of Monopoly unless someone speculates without considering the odds.
Although the definition of a strong balance sheet varies, the banker advising such in the second half of 2022 is astute. Do you have a strong balance sheet in your business (say 80%+ equity to assets), Congratulations! If you don’t know, talk with an advisor who can help you analyze and suggest actions to develop a plan to implement any necessary improvements.