Is Your Balance Sheet Costing You Money?

The Double Hulls of Business: Liquidity and Leverage

Liquidity: Part 2 of the “Unsinkable Business” Series

In my last “Unsinkable” post, I addressed the importance of designing the foundation of your business with double hulls. A double hull design of?Liquidity?and?Leverage, like the design of the Boston Whaler (a renowned small watercraft designed with a double hull to be unsinkable), results in an unsinkable business.

If either hull, Liquidity or Leverage, is weak, the boat struggles to stay afloat.

A deficiency in the Liquidity hull tests the ability of the business to pay its bills and meet its payroll obligations as they come due. Alternatively, an excess of Leverage (Debt in relation to Equity), limits a business’s options for sourcing the extra cash that may be needed to fund growth opportunities. Moreover, in a contractionary economic cycle, high Leverage further risks the firm’s ability to attract additional capital and?the relative cost of that capital.

Debt is akin to having IOUs on the balance sheet of a business. Too many IOUs, or other sources of debt, are perceived by lenders as elevated risk. This perception increases the cost of any capital that a lender would otherwise consider committing to your business.

When a business is disciplined about maintaining a healthy balance of Liquidity and Leverage, it is ideally prepared to sail safely through any change in economic weather. That advantage is directly reflected in a lower cost of capital relative to peer and competitor companies in their industry and markets.

Well-managed businesses consistently outperform their competition on Liquidity and Leverage ratios and, thus, attract a lower overall cost of capital. The lower cost of capital is reflected in the firm’s bottom line. It also passes through directly to the owner(s) of the business, in the form of a higher valuation of the business and, if an S-Corp, the potential for higher distributions. Capitalizing earnings at a lower cost of capital equates to a higher business valuation.

Shifting back to Liquidity

Liquidity is the?outer?hull of a business ship. Without Liquidity a business is unable to pay its employees or its bills. As the outermost hull, it is directly exposed to the pounding of the sea and the changing forces of the environment. In the case of business, those environmental forces comprise not only the economy and industry shifts, but also its strategic stakeholders: investors, employees, suppliers, key customers, and service providers.

Whether Liquidity or Leverage warrants designation as the outer hull is up for debate, however, Liquidity generally gets tested first as business conditions evolve.

Case in point: When a business owner and CFO must pivot to assure ample cash on hand to fund the next payroll or to meet a payment deadline to a critical supplier, rarely do they consult the right-hand side of the balance sheet (where debt, equity and leverage are revealed). Instead, they immediately shift their full attention to “How much cash do we have?” or “What do we have in receivables that we might be able to call and dial for dollars?” or?“How much availability – or unused borrowing capacity - do we have on our line of credit?”

Those questions are symptomatic of Liquidity deficiencies. Business leaders feel these surprises acutely when they can least afford to have their focus and attention diverted from core operational or strategic objectives.

Being in any situation that requires answers to those questions highlights an underlying and insidious cost associated with the deficient stewardship of Liquidity. Suddenly, critical executive management resources (time and attention) are diverted away from markets and customers to deal with a near-term cash crisis, namely paying payroll or suppliers.

In his 2018 book –?The 5AM Club?– author Robin Sharma refers to High Value Activities (HVA) as those activities that warrant the highest priority because they have the potential for highest impact. I suspect any business owner, CEO, CFO, or EVP of Sales, would classify a crisis-level meeting to determine if there is enough cash on hand to meet the next payroll as an HVA – albeit an undesirable one. The opportunity cost associated with such a fire drill is difficult to justify.

A more subtle cost stems from the negative impact on the trust and confidence key stakeholders have in the business. Business is about trust and confidence. Do customers trust and have confidence in your products or services and your ability to deliver them? Do your suppliers have trust and confidence in their prospects for receiving payment? Do employees have trust and confidence in their prospects for receiving payroll checks? Do landlords have trust and confidence in their prospects for receiving lease payments? Does your bank have trust and confidence in your prospects for repaying their loans? Do investors have trust and confidence in their prospects for receiving a decent return for the risk they took in investing in the business?

Balance sheets matter

Traditionally, the income statement receives more management attention than the Balance Sheet. Assessing revenue growth, gross margins, and trends in operating expenses as a percentage of revenue all attract the discerning eyes of leadership.

The income statement provides a snapshot of a period of time – i.e. a month, a quarter, a fiscal year. The attention is warranted and an important reference to gauge how the organization is performing against its budget plan. However, balanced attention to?both?the income statement and the balance sheet is rewarded.

If you were to ask your banker if he or she thinks your company’s balance sheet matters, I know what their answer would be. Additionally, if you were to ask the CEO or CFO of your bank if the bank’s balance sheet matters, I know what their answer would be, too. The answer is?Absolutely!

In fact, there is a whole discipline in the banking industry known as?Asset Liability Management (ALM). Banks that have rigorous practices around ALM are those that generally outperform their peer group. They also earn the confidence of supervisory regulatory bodies, investors, and other stakeholders, as they are perceived (and often rated) as possessing strong performance and risk management practices.

What do you guess the core elements of ALM might comprise? You guessed it –?Liquidity and Leverage.

If you wish to impress a bank, you can level the playing field by confidently demonstrating your knowledge and ability to optimize the performance of the Liquidity and Leverage “hulls” of your business.

Recommendations

Develop a habit of routinely assessing the integrity of your outer hull - Liquidity.

Each day, ask your CFO about your liquidity position. Has it changed since last week, last month, last quarter, last year at this time? It is an easy exercise. You’ll be glad you did when the inevitable surprises and storms of the market buffet your business.

Focus on what you can control.

You can demonstrate to any potential source of capital that you understand and are focused on the financial levers in your business - and are proactively adjusting to improve performance where warranted.

By following these suggestions, you retain more money in your company, reduce what you pay to creditors, and improve control of your business finances and conversations with your strategic stakeholders.

Chances are your business is not a bank. Chances also are your business depends on a relationship with a bank and/or other sources of capital to achieve your growth plans. Don’t leave your balance sheet to chance.