Always look at the balance sheet

Things may seem to be going swimmingly, until a check of the balance sheet shows you are up the creek.

“Things are great…sales are up 20% and future prospects are terrific,” a client tells me. Another says about his business: “Things are fantastic. I look at the bank balance and it is in great shape at the moment.”

I say to them both: “That’s great, but have a look at your balance sheet.” So many key performance indicators provide great guidance and comfort to management, but sometimes they can be misleading, and in some cases so misleading as to cause bankruptcy.

Growth is a tricky thing, and in order to manage it effectively we need to have a handle on really fundamental issues. Otherwise we could develop a false sense of security. Growth so often involves working outside your comfort zone.

So, why look at the balance sheet when sales are up or the bank balance is in good shape? The reason is that the balance sheet is a history book written by the people in the organisation, and there is something inevitable about history. As Karl Marx once said: “History repeats itself, first as tragedy, second as farce.”

I have seen a construction business turning over $50 million a year with a great bank balance and substantial sales growth, but big problems.

Management told me how fantastic things were. BMW X series sedans lined the parking lot. “Our accountants have valued our business at $X million,” they said. The balance sheet looked great. Assets exceeded liabilities by a more than healthy margin and there were some millions of dollars in the bank.

So I talk to the staff — the people who have written the balance sheet — to get the story behind that balance sheet.

The receptionist told me who took the most calls. “Accounts payable,” she said. “They get dozens.” I then had a talk to some of the workers. “What are your main frustrations?” “Rectifications,” they said. “We never seem to have time to do rectifications. We are always moving to the next job and it drives us crazy.”

What does the balance sheet now tell me? One of the assets is “retentions”. This totals $10 million. I ask people what the retention rate in their contract is and they say “5%”. Heavens! 5% of $50 million comes to $2.5 million — so why are the retentions so high?

I remember what some of the workers told me, that rectification is a problem, so I conclude that customers are unhappy because rectification has not been done with the result that a lot of the $10 million is unrecoverable. It should only be $2.5 million.

I then look at the debtors (the amount owed to the business by customers) and these are within industry standards. I then look at creditors and they represent four months of outgoings. In other words, creditors haven’t been paid for four months. So I check with the accounts staff and I am told that they delay payment of creditors for four months.

By the time that you adjust the balance sheet to accord with the stories of the people who have written them, it looks sick.

The money in the bank ought to be in the hands of the creditors, but if it were, then there wouldn’t be any money in the bank. In fact, unless management could do some quick talking, it would be out of business because it doesn’t have a facility. Then you knock $7.5 million off the retention amount and suddenly the balance sheet is sick and the liabilities exceed the assets.

The balance sheet goes back to the accountants. They then say that the business is worth zilch.

I don’t know how many times I have come across businesses that are going “great” only to find that when you look at the balance sheet and talk to the people who write that history book that the real problems confronting the business are unearthed.

If dealt with in a timely fashion, the business can survive and grows. However, the sicker the balance sheet, the less likely it is that the business will grow.

What I have learnt is that too few understand the relationship between the health of a balance sheet and the stories of the people in the organisation. That brings me to another story, which will keep for a future blog.