Do you manage your company’s balance sheet as aggressively and meticulously as your income statement? If not, you should! Why? Because balance sheet management is what keeps cash flowing! Anyone who’s been in business for at least a year can recall a time when bottom-line profit was strong and cash was non-existent. To keep cash flowing, you absolutely must manage your balance sheet. Here’s a very simple, easy-to-follow five-step plan.
1. Start with an equity percentage target. Equity is defined as assets minus liabilities. To find equity percentage, just divide that amount by your total assets. For instance, a company has $5,000,000 in total assets and $3,750,000 in liabilities. The equity percentage would be 25% ($1,250,000 equity divided by the $5,000,000 in total assets). What should your equity target be? Most bankers want at least 25%, and an industry benchmark for wholesalers is 33% with about 30% for retailers. These should be considered minimums. Anything above that percentage is fine as long as your company is earning a good return for the money you have invested there.
To check your return on equity, divide your annual profits by your equity. In the example above, if that company were only earning $100,000 per year, they would have only an 8% return on equity, which is rather low. A normal investor could earn 10% to 12% just by plopping his money in a mutual fund with no drivers, no trucks, no employees, etc. This also means that when you allow your equity to get too high, you may not be getting the biggest bang for your hard-earned dollar.
2. Your next target depends upon your company’s sector focus. If you are a wholesaler, your next balance sheet target is receivables. (If you are a retailer, skip this target and go right to the discussion of inventory targets in step 3.) Your receivables target should be expressed in terms of Days Sales Outstanding (DSO). To compute this target number, divide your receivables dollar amount by one day’s average sales. Your target should be very close to your selling terms. If you use a variety of terms, for instance, 10 days on fuels, 30 days on lubes, you will need to see the percentage of sales in each term category, and then derive the correct DSO given your product sales and your terms. For a target, use 115% of your average terms. For instance, if you compute your average terms at 16 days, your DSO target should not exceed 18 days (16 days times 1.15).
3. Any company with inventory should have a company-wide inventory supply target. This target should be no more than 1.5 times your supplier terms. Again, you’ll have to do a little math to find out an average for your company since you may have different vendors with different delivery schedules. But let’s assume you have pure retail operations with weekly supply. Your company-wide inventory target would be 1.5 times 7 days or a maximum of 11 days of inventory on hand. To calculate your average inventory supply, divide your inventory dollar total by your average daily cost of goods sold. If your result looks very high compared to Meridian’s suggested target, do not delude yourself into thinking your company has special circumstances. That’s just an easy excuse for poor inventory management. Every extra $100,000 you have in inventory, above Meridian’s suggested 1.5 times your supplier terms, costs your company $10,000 a year to support!
4. Next we’ll set a bank line maximum dollar target. Your target will exactly equal your inventory and receivables less your accounts payable. If you owe your bank more money than that on your line, you are using that line to finance fixed assets, which will lead to bigger problems later on down the road. If you’ve already blundered, have your banker “term out” the excess borrowing on your line on a five-year note. That will strengthen your current ratio and help you get rid of that debt.
5. Purchase any new fixed assets with long-term debt support. How much debt? Well, that depends on where your company is in relation to its equity target. A company with too little equity (defined as less than the 25% bankers want) should use less aggressive financing and more of their own cash until their equity gets stronger. Old, long-time companies with large equity positions in excess of industry norms can get very aggressive with debt (up to 100%) without damaging their balance sheet position. Note that the strategy suggested is contrary to many marketers’ actual debt practices today. Typically, the higher leveraged the company, the more financing they want! This heavy reliance on debt, however, can quickly get a company into trouble when profits don’t meet expectations and there is no cushion anywhere on the balance sheet to absorb losses.
So, you now have the five basic steps you need to take to keep your balance sheet healthy. Once you’re consistently reaching your basic five targets each month, it’s fine to set targets for your other balance sheet liability and asset accounts that will reduce prepaid expenses, minimize accrued expenses, keep intercompany transactions to a minimum, etc. The majority of your company’s balance sheet health and strength, however, can be achieved by just careful attention to the five basics. So, set your targets and watch your cash grow!