Rich Business, Poor Business Part III

In my last post, I talked about ways to use Assets as a tool to make better business decisions. On the other side of the balance sheet are Liabilities and despite the negative connotation that is often assigned to them, they can be a friend to your business.

Below are definitions of the most common liabilities:

Current Liabilities

Current liabilities are obligations your business has to pay in a current period of time (usually within one year). Typical current liabilities include:

• Notes payable (12 months of loan payments)
• Accounts payable/trade credit
• Sales tax payable
• Accrued payroll
• Payroll taxes payable
• Gift Certificates/Gift Card Redemptions

Long Term Liabilities

Long term liabilities are simply obligations that mature in greater than a year’s time, such as term loans (greater than a year) and mortgages. For some larger corporations, bonds would also be considered a long term liability.

You may have noted that both definitions contain the term “obligations.” I have heard quite a few different sources refer to liabilities as “other people's money” or “OPM.” I don't think that is an appropriate descriptor. Liabilities are funds that are supposed to be paid back; borrowers are using their own money, they are just receiving it ahead time from other sources. Those who do not pay back their liabilities on agreed terms could end up with a poor credit history or even in bankruptcy court, making it much more difficult to get access to liabilities at a future time.

Through my position as a business counselor, I have obviously come across people who have bruised or damaged credit and there are often extenuating circumstances that attributed to those issues. While I can sympathize with such clients and try to help in anyway possible, such clients should also understand the lender’s position that it is difficult to extend credit to those who have failed to meet obligations in the past.

Another thing to remember about liabilities is they are usually extended to businesses at a cost. Whether that cost is interest, finance charges, late fees or penalties, financing activity usually generates expenses. Any plans to borrow money should include an analysis of whether the business model will generate profitability at levels that exceeds the financing costs.

In a previous post, I made the statement, “the goal in building wealth is to have a higher net worth, which means to have more assets than liabilities.” Please do not interpret this to mean that you should try to eliminate liabilities from your balance sheet. Again, the key to building wealth is to have more assets than liabilities, but sometimes you need to utilize liabilities to get more assets onto your balance sheet.

“Rich” business owners are apt to utilize liabilities quite often to grow their businesses. Their key to success is that they are very judicious in how they leverage their capital and have a good understanding of the difference between current liabilities and long term liabilities. They do their best to utilize current liabilities to preserve cash and finance inventory and accounts receivable. They utilize long term liabilities to finance fixed assets.

Another thing successful business owners do before taking on debt is to analyze some key ratios before making their decisions. The three tools they used most often are a debt ratio, a current ratio and an acid test analysis. The purpose of all of these ratios is to measure how much of their business is leveraged to obligations.

The debt ratio is simply your total liabilities divided by your total assets.

Debt Ratio = Total Liabilities ÷ Total Assets

Anything greater than one is a sign that your business is over leveraged with financing. It also means that your business has a negative net worth (“poor business”). In his book, Don’t Squat with Your Spurs On, Texas Bix Bender writes, “if you find yourself in hole, the first thing to do is stop digging.” Any business that has a negative net worth should do some serious evaluating of profitability potential before taking on more obligations, as this may be a sign that the business does not have enough earning power to meet their obligations.

The current ratio looks at just your current assets and liabilities.

Current Ratio = Current Assets ÷ Current Liabilities

This ratio indicates a businesses’ ability to satisfy obligations in the next year. For this ratio, any number less than one is an indicator that your business is leaning towards being over leveraged with too many current liabilities. It is not necessarily an indicator that a business will fail, but it does mean that it is in a position where your business could not meet all current obligations, even if all inventory was liquidated and accounts receivable collected. Should this be the situation, a business would have to have projected profitability, or access to some other capital source, within a year to cover those obligations.

The acid test is another tool that is used. It is the same as the current ratio, except inventory is taken out of the sum of current assets. The reason this is done is because wise investors recognize that most inventory is not always easy to convert into cash. So the acid test is:

Acid Test = (Cash and Cash Equivalents + Accounts Receivable) ÷ Current Liabilities

Like with the current ratio, a ratio greater than one is desired. Should a business have a lower percentage ratio, it may be difficult to access short term capital.

As business counselor, I have often come across balance sheets (including for my own business) that have had debt ratios greater than one and current ratios/acid tests with ratio numbers significantly lower than one. Why does this happen? The reasons vary. There could be legitimate, temporary challenges, catastrophic single events or just a history of small mistakes in judgment. It is critical to remember that a balance sheet is a snapshot of a given point in time and circumstances may change dramatically in the future.

Again, I provide the reminder to forecast what could happen before making rash decisions. Look for ways to match long term liabilities to your fixed assets and increase liquidity. If you are going to tap into a credit line for some short term liabilities, hopefully you have assessed that you are going to make quick sales, turn more inventory or collect on receivables before the debt matures. There are often quite a few options available to better manage your financial position, if you invest the time to gauge the impact of your decisions.

In all cases, the key to success is to utilize liabilities only to finance assets that will generate net income. Leveraging financed money to cover operating expenses is what gets most small business owners into trouble. Once that money is spent, it is gone and the borrowed money will probably generate more expenses. The hole will keep getting deeper unless there is something on the asset side of the balance sheet generating income. Whether it is a current asset like inventory that will turn, a fixed asset that produces a product, or even an intangible asset like intellectual property relating to services you sell, your assets will have to generate profitability if you are going to increase net worth.

Feel free to post comments with questions or suggestions and remember to pay attention to your balance sheets when making business decisions. Risk is inherent in all business decisions, but the more you calculate those risks, the more likely you will achieve success.