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Company faces hard questions on state of its balance sheet

(Editor’s note: This is another in a series of columns exploring the financial challenges facing a company.)



“Anyone who lives within their means suffers from a lack of imagination.”

– Oscar Wilde



Tom Sampson, the controller for Ace Business Stuff, was in his office considering how to explain to John Wilson, the CEO, the issues related to the company’s borrowing capacity and the weaknesses in the balance sheet.

Tom had put together several schedules for his meeting with John that afternoon but was still struggling with how to get across some of the subtleties that he knew the CEO would want to understand.

 Tom knew that his CEO was absolutely committed to the company’s success but got very frustrated when his convictions about future performance collided with the bank’s concern about its current financials.

Tom knew that the bank considered many factors when judging an asset-based loan. Sufficient collateral to support the company’s borrowing request was only part of it. A key ingredient was the quality of the collateral. Tom had repeatedly expressed concerns about the company’s liberal return policy as well as its lenient collections policy.

He knew the bank would examine the company’s historical product return rate and its collections policies. It was likely that the generally accepted 80 percent advance rate against receivables would be reduced by the bank given the company’s product return rate of around 7 percent, meaning that the company only netted about 93 percent out of every sales dollar.

 Tom knew that the return rate was unacceptably high and, while they were working on it, they hadn’t made much progress.

Also, their bad debt expense was 5 percent last year because they failed to uncover a struggling customer before it went out of business. The bank would calculate that the 93 percent value of every sale is really more like 93 percent minus 5 percent bad debt, equaling 88 percent.

That 8 percent margin over the 80 percent advance rate may not give the bank a sufficient cushion, meaning that the company would probably be offered a lower advance rate.

“Hi Frank,” Tom said when he reached the company’s warehouse manager. “John and I will be visiting with our bank next week, and I wanted to get an update from you on some of the older inventory we still have on hand. Any movement on any of that?”

“Not really, Tom,” Frank replied. “I’ve reminded the sales guys every time they wander through here, and I know John has talked to David about it.”

David is the company’s sales manager, a capable executive but one who, in Tom’s opinion, always looked forward to next season’s products without much accountability for inventory already on hand.

 “Tom, you know John. Like the rest of us, he hates writing stuff off, but some of it , well, I don’t think the customers really want it anymore.”

“Thanks, Frank. I know I need to talk to John further about it. I’ll get back to you with whatever I learn.”

This is why the company’s inventory turnover is declining, Tom thought. He knew that the sales department, with John’s tacit support, was unwilling to reduce prices on products that an outsider might consider obsolete, believing that they could be sold if they could just find the right customer. They rarely did, so the inventory just sat there. Once the salable inventory was segregated, the common 50 percent advance rate for inventory might also be under attack.

Tom considered various ways to overcome these issues but also realized that the company’s balance sheet was working against him too. He didn’t have a current schedule handy, but he knew he needed to update their various ratios so he could show John, in black and white, exactly what was going on.

Tom knew that their current ratio was tolerable but not great. It was a well-established measure of a company’s liquidity, which compared current liabilities against current assets to measure whether the current liabilities could be paid as the current assets converted to cash. A higher number demonstrated the company’s superior ability to generate cash to pay its short-term obligations.

 Tom realized that a greater concern would be the “quick ratio,” which was not very strong, barely half the size of the current ratio. It measured the total of cash and accounts receivable only, excluding the inventory, against the company’s current liabilities. This ratio was a closer measure of liquidity, referring to how quickly the company could generate cash.

Since inventory had to be sold before a receivable was created, this ratio showed that the company would really struggle with its current obligations unless its inventory was sold on a timely basis.

A lot was on the line. They weren’t just asking for a collateral loan. It was a balance sheet loan, too, and Tom hadn’t even dealt with those issues yet.

“John,” Tom said when he got a voicemail recording. “I’ve got a few more things I’d like to prepare for our meeting, a few more schedules I’d like to put together. I’d like to push our meeting out by 24 hours so I can be better prepared and show you a more comprehensive picture.

“I’ll give you a call in the morning to reschedule our meeting.”

Stay tuned.

•••

Lary Kirchenbauer is the president of Exkalibur Advisors Inc., providing practical business strategies for family and other privately owned businesses in the middle market. He works with senior executives and their businesses to accelerate their growth and improve personal and professional performance. He can be reached at 415-602-7870 or lary@exkalibur.com. His Web site may be found at www.exkalibur.com.