Some companies are focused on driving sales. But a narrow focus on sales often means overlooking collection of accounts receivable or improperly managing inventory turns, which can lead to cash flow problems that can cause serious difficulties.
“There comes a time when the financial sophistication of the company has to be upgraded,” says Dan Culp, vice president and commercial relationship manager at Home Savings Bank. “Otherwise, sales might continue to grow, but margins stagnate or shrink.”
Smart Business spoke with Culp about the importance of a company’s balance sheet, and how to put it to best use.
In what ways are companies not making the best use of their balance sheet?
Many companies are not diligently monitoring accounts receivable and inventory, and converting to cash quickly, which can cause a cash flow crunch. When this happens, companies stretch their accounts payable to their vendors, which can potentially harm the relationship.
Another common practice that is not recommended is that many companies distribute nearly all of their profits to shareholders on a yearly basis. However, completely distributing earnings annually does not allow the capital base to grow on the same potential trajectory. If the company hits a road bump in future years, there may not be a nest egg to fall back on.
Also, stretching out debt over the useful life of any fixed assets can hinder the balance sheet. Companies should always want to be in a positive equity position on any income-producing fixed assets. Don’t buy an asset with a seven-year useful life on a ten-year loan or you’ll have debt left to pay after the equipment has been disposed.
What should companies do to make the best use of their balance sheet?
Keep some cash on the balance sheet. Although in today’s interest rate environment, that may seem unproductive, it is still wise to have a rainy day fund.
Focus on the conversion of accounts receivables and inventory into cash.
Maximize terms provided by your vendors, but always pay within those terms so the relationship stays strong. If a company is paying its vendors on an average of 14 days, but their receivables are averaging 30 to 45 days, the company becomes upside down from a working capital standpoint and a cash flow crunch will quickly ensue.
Use debt as a growth tool, but do not become over-leveraged. Most banks will monitor debt levels and use covenants to make sure leverage is in line and appropriate for the company. Ideally, companies implement strategies that improve cash flow to a point where they are funding their own working capital and growth.
What should companies expect to see once they make better use of their balance sheet?
A company can expect to see improved cash flow, equity positions, overall health of the organization and value of the company. This puts less stress on management and the entire organization.
From a financing perspective, a stronger balance sheet will lead to more favorable lending terms for the company because the risk profile is lower. This can lead to lower rates and fees, longer terms, higher advance rates, or the reduction or release of personal guarantees. If the company can stand on its own merit, without the shareholder’s support in a downturn, non-recourse can be considered.
Having a strong balance sheet also shows a history of strong earnings. This gives the company more buying power as an acquirer or drives up its value/sales price as an acquisition target.
Once cash flow is not a stressing issue, the company can focus on other items — driving profitable sales, strategic growth initiatives, making other investments in the company — without the need for debt or expense reduction. It also takes a lot of stress off the owners and the organization when they know they have enough cash to make the next payroll. The entire energy of a company can change.
Having the right accountant, banker and a capable controller or CFO is critical. Having a strong team of outside partners is just as critical as the internal partners.
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