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Balance Sheets 101

Dear Dave
Our bank has put us on notice that our balance sheet measurements as of the end of last year are no longer adequate to support our loan.  Specifically, they tell us they are bothered that our debt to worth ratio is 3 to 1, and our current ratio is 1 to 1.  As a result, the bank warns that it will be reducing our line of credit limit when it renews later this year and requiring the personal guarantees of our two major principals. We use our line of credit on a regular basis to even out our cash flow and can’t afford to have our credit limit reduced.  What should we know about balance sheet measurements?  What can we do about this?

Dear JE
A balance sheet is one to two principle financial statements, the other being an operating statement sometimes more commonly referred to as a profit and loss statement. A balance sheet reflects the capital structure of a firm (what you own and what you owe).  An operating statement tracks the flow of income and expenses generated by your business activities.  Ideally, both a balance sheet and an income statement are prepared at the end of each accounting month during the year, and a final, accumulated report for each is prepared at the end of the year.

A balance sheet is often formatted as two side-by-side columns.  It is called a balance sheet because the dollar total at the bottom of the left and the right columns must be exactly equal for the balance sheet to “balance”.  Assets are recorded at their accounting values on the left, and liabilities and owner’s equity (also known as net worth or book value) on the right.  A series of bookkeeping adjustments are made each month adjusting the dollar amounts recorded on the balance sheet to reflect their then current accounting values.

The message the balance sheet purports to offer is this: if all the assets were sold for the value reflected as of the date of that particular balance sheet report, and all the liabilities were paid off from the proceeds of the asset sales, the amount remaining would be left over to distribute to the firms owners (owner’s equity).   Stated as a formula, assets minus liabilities equals owner’s equity.  

The debt to worth ratio is the traditional grand daddy of all measures used for assessing the financial stability and risk inherent in an organization.  The debt to worth ratio comes from dividing a firm’s total liabilities by its owners’ equity. A debt to worth ratio of 3 to1 means that the creditors have three dollars invested (at stake) in support of the firm’s assets for every dollar of investment by the owners. The higher the ratio, the more “leveraged” a firm is said to be. The more leveraged the firm is, the more disproportionate the risk for lenders and other creditors to maintain or extend additional credit to the firm.

Published surveys of financial statistics find that the median debt to worth ratio for engineering and architectural firms to be consistently around 1 to 1, which is actually quite benign and healthy.  As a former banker myself,  all other things being equal, I typically did not flinch or get unduly nervous until a client’s debt to worth ratio edged up to 2 to1 or higher as a general rule of thumb.

The current ratio is found by dividing current assets by current liabilities. A current asset is cash and other assets such as accounts receivable and work in progress that one would ordinarily expect to covert to cash within the coming twelve month period.  The single largest current asset usually held by professional firms is its accounts receivable (or as I tease my clients, your “I owe me’s”).  Similar in definition to a current asset, a current liability is any obligation which will be due and payable within the same twelve month period. 

A current ratio of 1 to 1 indicates that for every dollar of debt coming due over the next twelve months, there should be one dollar of cash on hand to meet that obligation.  The higher the current ratio, the more “liquid” or “covered” a firm is said to be. At one to one, there is no cushion or margin for error which would lead a creditor to anticipate that your firm may be likely to experience problems from time to time meeting cash payment obligations as they come due. Surveys report the median current ratio for engineers and architects to be around 2 to 1.

To bring your firm’s ratios more in line with industry averages, and to allow your banker to feel better about your relationship, you need to work toward accumulating some additional capital within your firm. There are basically two ways to accomplish this.  The first approach is to ease up on the amount of the firm’s discretionary profits you distribute each year and holdback a larger portion of your profits within the firm as retained earnings.  Retained earnings add directly to owner’s equity and help in reducing the firm’s reliance on credit lines and other loans to support firm operations.  The second basic way to raise capital and reduce debt dependence is for the firm to sell additional stock (or ownership) positions to willing investors.

Capital is the lifeblood of organizations. Keeping your ratios healthy and your cash flow strong is fundamental, Business 101. Without adequate capital your firm will not only have difficulty meeting your day-to-day operating needs, you won’t have the resources to invest in the technology and tools needed to keep your firm current and competitive.

Finally, when you do go to discuss your balance sheet and loan arrangements with you banker, never go alone unless you’re very knowledgeable in these matters. Take along your firm’s outside accountant or attorney to help you negotiate.  Signing personal guarantees allows the bank to collect from guarantors as well as the firm in the result of a business reversal. Guarantees should only be considered as an extreme last choice option.  If the bank still insists on reducing your credit limit, or remains adamant about personal guarantees, get the bank to commit up front what specific future financial conditions need to be reached to release you from the guarantees and raise back your limits.

Wahby and Associates