By Richard Tyson
My client was clearly agitated. This was in distinct contrast to his typical demeanor. Normally, he was both optimistic and enthusiastic, but not today. He shared that while his top-line revenue was growing, he was increasingly having trouble paying his bills. Revenue was great, but cash flow was tight.
While there can be a number of contributing factors to this problem, I suggested that we initially shift our attention from revenue and cash flow to the client’s balance sheet, specifically examining his accounts receivable. How much was he owed from his customers?
This simple question led to an immediate and important insight. His accounts receivable balance was huge when compared to his monthly revenue — and it was growing every month. Further investigation led us to discover that over 30 percent of his annual revenue was uncollected. Receivables that should have averaged 30-40 days were aging at an average of 90-120 days.
While many businesses employ a receivables manager, this client did not. In fact, as we discussed his current problem, he confessed that he “never felt the need for an A/R manager; the dollars just always kept rolling in.”
This exposed an issue that can afflict any of us: the attitude that “if it ain’t broke, don’t fix it.” Of course, in this case (and quite often), it really is broken; it just hasn’t yet presented itself as a nasty problem.
So, the nasty problem was identified. Following up with customers on their unpaid or partially paid balances needed immediate attention. Fortunately, we weren’t too late to address the issue, and within a few months my client’s cash flow problem was resolved. Thus, the first essential balance sheet insight: Know how much is owed to you.
The second insight is akin to, but opposite, of the first: Know how much you owe. Effective management of your accounts payable is also essential. Failure to manage this will inevitably result in poor vendor relations (when bills are paid slower than agreed-upon terms) or constrained cash flow (when bills are paid more quickly than is necessary).
One client years ago was informed that he had won the Irish Sweepstakes and that a large sum of money was forthcoming. He was sure there was some mistake; he had never purchased tickets in that lottery. After some investigation, however, it was proven that he was the winner.
How? A European vendor had purchased the tickets, using money that my client had overpaid on his invoices. The vendor had tried to return the overpayments, but when they continued over time, he instructed his A/R people to take the excess and buy lottery tickets for my client. The ultimate windfall was, of course, appreciated, but more importantly, it exposed the need to pay much closer attention to the company’s accounts payable management.
The third insight is a combination of the other two: Track the liquidity health of your company. This is done through what is known as your “working capital ratio,” or “current ratio.” This simple formula — current assets divided by current liabilities — is widely used in the financial community. As a basic rule of thumb, you want this ratio to be greater than 1, which simply says you have enough assets that are readily convertible to cash to cover your current bills.
Depending on your industry, you may get a clearer picture of your liquidity if you subtract your inventory from your current assets, since it may not be realistic to assume that you can quickly convert inventory into cash (this amended ratio is sometimes referred to as the “acid test” or “quick ratio”).
Your best use of these ratios is twofold: First, in comparison to your balance sheets from prior periods, so that you can see how your liquidity is trending, and second, in comparison to other companies of your size in your industry. Such comparative data is available from several sources, such as RMA (Risk Management Association).
All three of these insights require that you keep your balance sheet up to date and accurate. With timely and meticulously prepared monthly balance sheets, such insights will constitute critical key performance indicators for virtually every business, small or large.
Richard Tyson is the founder, principal owner and president of CEObuilder, which provides forums for consulting and coaching to executives in small businesses.
