In the early days of my training we were introduced to balance sheets and it was something that remained a central theme in exams, getting to grips with the vital ratios being an imperative.
However, once we were let loose on clients such technical details became less relevant. All they wanted to know about was their bottom line and how much they could take out as a dividend or as a year end bonus.
For years I felt like a lonely voice in the wilderness when explaining with exasperation to clients and friends how important it was that they lived within their means. Put simply, if you are making £50,000 a year in profits your lifestyle should be supported by drawings way below £50,000. Even for a cash business with little or no debt there should be a reasonable cushion upon which to rely in if disaster struck.
But disaster doesn’t strike, does it?
It only happens to other people, or perhaps they had critical illness insurance. No worries there then.
But what about a wider economic problem or a fundamental change to their operating model out of their control? Simply not on their radar, they just lived for the present, especially as the early noughties boomed under New Labour and globalisation.
What they were blind to was that over a period of several years they could have built up a substantial cash balance, some of which could be used to invest elsewhere, typically in commercial or residential property which itself brings in an income.
In reality the balance sheet was always empty.
Mind you, there were no borrowings and it was a cash business so did it really matter?
Actually it did.
Being able to visualise the net worth of your business, especially over time, puts into perspective what you have achieved and allows you to husband that wealth properly. Fast cars, expensive holidays and fine living don’t quite cut the mustard, although I must admit the fast car has a certain appeal, but my mid-life crisis isn’t the topic of the blog, but think Bentley and you’re on the right track.
Crank everything up a bit and the business has grown with staff, debtors and creditors and the concept of the balance sheet takes on an altogether new meaning. Micro and SME businesses now need to pay much more attention to what calamities may present themselves. It’s no longer about you and your lifestyle alone, there are employees and suppliers to consider.
This is where the ratios I fleetingly mentioned earlier come into their own, especially over a period of years as trends emerge. You can’t rewind the clock, and when I sell an accountancy practice and come across mounting unpaid fee balances I sigh to myself and tell the vendor “cobbler’s children going barefoot” – it is an expensive error, but I can guarantee you that the ratios were never calculated.
It’s exactly the same when selling industrial businesses, which is what I also get involved with. Creeping uncollectible balances that slowly destroy the ratios show up in stark relief over a period of time, if of course somebody is actually reading and analysing the balance sheet instead of seeing how much cash is in the bank to extract a dividend to cover the luxurious lifestyle of the business owner.
It’s an age old affliction that SME owners suffer from – is there cash in the bank and can I afford my cruise this year? Yes I can. Great.
Admittedly, it can be difficult for them to explain to a spouse why they are working so hard but cannot afford 3 luxury holidays a year, but perhaps, just perhaps, if their accountant was tuned into the balance sheet story and hammered home the message, it could be understood that one has to look at the wider picture.
I suspect that it will take some time and many conversations for the emphasis to swing back form profit and loss to balance sheet.
The above is without even considering the effect of debt on the business.
SME owners can see how much they pay in interest as that is on the profit and loss account but to truly understand the effect of capital repayments on their net worth it needs a certain respect for the balance sheet, something that only comes into play when it is too late.
A couple of years ago I was advising on the purchase of a successful business. My role was to perform the due diligence and assist with cashflows for the finance providers. As things progressed I made it abundantly clear to the purchaser that he was overleveraged and the purchase was too tight. He did not dismiss my concerns but nonetheless proceeded with the purchase. After all it was a good business with much potential in what I would consider a fairly defensive sector.
About 3 months ago she was back, almost begging me to assist in raising equity from private investors. I reminded my erstwhile client about my warnings 2 years prior ,which were now sheepishly acknowledged.
It came to me as no surprise as the last vestiges of my invoice to her remain unpaid.
What also may bring balance sheets into sharp relief is the interest-free government backed loan scheme. Criteria will include whether a business was viable prior to the virus. Surely the balance sheet will play a part in the decision making process, at least requiring firms to have a positive net worth even if not of any great substance. The magic words on gov.uk are “…not an undertaking in difficulty at 31st December 2019” . How does one interpret a negative balance sheet?
Could this be the watershed moment for SMEs and micro-entities or will we follow the British tradition of dropping the ball and wasting a golden opportunity?
Swiftly moving on then.
Secondly, as an investor in shares I have certain yardsticks or criteria which guide my investing. Most of it for the medium to long term – that is indeed a fundamental rule of investing. Some is for short term trading or the thrill of the chase.
I look at earnings ratios and dividend policies in the main, from a financial aspect. But I also consider debt, in particular pension liabilities that can lurk unseen in eventual quantum, like an iceberg.
The question that will come to the fore is whether so-called dividend heroes will reconsider their policy of paying a generous percentage of profits as a dividend. The ramifications of this will hit those relying on income quite hard but in terms of actual share prices I reckon it will rebase valuations downwards.
Rainy day funds will start to pop up everywhere, although to many listed companies a pile of cash sitting around is an anathema, as it lowers the return on capital. The boardroom lights will be burning well past midnight across the land as directors grapple with a response that is measured and reasonable, without hurting their own interests too much. Oops, did I really say that?
So a double-whammy then. Loss of income and loss of capital.
A timely reminder of the perils of investing in stocks and shares.
Conversely, it also represents a good buying opportunity to pick shares in “good” businesses with sound long term prospects. Just don’t expect the share prices to move upwards quite as swiftly as they may hitherto have done.
As for those companies who have been considered miserly with their payout, it is unlikely to affect their valuations as they will still have a comfortable cushion going forward. It could well boost their stock values as they will be seen as survivors – firms whose unbroken record of dividend growth can be maintained. There is a certain something about unbroken dividend records and a lot of song and dance accompanies it.
One can hypothesise ad nauseum as to the effect on particular sectors and individual shares but will there be a ripple effect into the unquoted sector?
Private company sale valuations are often influenced by the PE ratios for quoted firms in their sector. Also, the return a buyer will seek on their investment could rise as they require a higher return for their risk, now with an added dimension hitherto nowhere near their radar.
Or perhaps investors all round will simply accept that they have to assume greater risk for the same level of return.
Much will depend of course on the attitude of sellers – will they accept lower prices or will we see a Mexican stand-off?
It’s going to be interesting as this unfolds. Short term there will definitely be upsets as more sellers are likely to crawl out from under the rocks, either worried about a future pandemic or due to cashflow issues as a result of this crisis.
Longer term the market will settle and find its equilibrium.
But the biggest influence could now be the return to prominence of the balance sheet even for sales that are not asset-heavy. The profit and loss account isn’t going away any time soon but the multiple is likely to be tempered by a heavy dose of balance sheet input.