The Third Way We Use the Balance Sheet
to Make Decisions

December 2004

The balance sheet tells us three crucial stories. First, it tells us who owns the business. Second, it tells us how lean and mean the organization is running. And third, it tells us how liquid the organization is. In October and November, we covered the first two stories. Let's cover the last story in this newsletter.

The Third Question the Balance Sheet Answers: How Liquid Is the Organization?

One of the best things to do to understand the financial health of the organization is to see how the balance sheet would shake out if the company liquidated.

Liquidity is one of the more intuitive business terms. Have you ever seen those Oriental rug liquidation sales? What are they trying to do? They are trying to convert all the rugs into cash so that they can go overseas, hang out with their families for a while and buy some new rugs.

When you or your organization is liquid, it means that that you are flexible and strong like water. Water can seep in anywhere and do anything.

If you have $100,000 in your pocket today, you can go out on the town and have a rip-roaring time. If the same $100,000 is tied up in your house - enjoy cable. You aren't going anywhere.

Let me give you a story of how illiquidity can hurt a business. When I graduated from the University of Texas in Austin, one of the top employers in Austin was a company called Tracor. Tracor was a defense contractor and I knew many engineers who worked there and were very happy. Tracor had a huge campus with about 10 buildings with underground parking and a snazzy cafeteria. Deer ran through the campus and the test labs were full of fabulous equipment that would make any engineer proud.

Tracor was growing and doing great until the political environment changed. When the Democrats came into office, spending on weaponry slowed. And Tracor, who had all their money tied up in those wonderful facilities, expensive engineer salaries, and long-term, slow-paying government contracts choked. They were illiquid and the layoffs began. Every day my engineer friends would go into work not knowing if they'd still be employed at the end of the day. Now Tracor is gone and other companies occupy their buildings.

Contrast this with the largest employer in Austin now, Dell. Dell is highly liquid. They do not have fancy buildings or equipment. I've never seen a deer on campus - although they do have nice cafeterias. Dell, at this moment, has nearly $10 billion dollars in cash. Very little of their resources are tied up in inventory or facilities. When the market turns down, as it does every so often, Dell is able to withstand the downturn because of all this extra cash. They are liquid and can respond to opportunities in the marketplace faster than competitors who do not have all that cash.

A Pretend Liquidation

Let's pretend we are a simple manufacturing operation. But all of a sudden, our owners have decided that they are tired of striving to make shareholders happy and want to start a spiritual retreat center in the mountains of Montana. They plan on liquidating the business and giving all the employees a nice severance package and moving as soon as possible.

So the first thing they do is stop paying utilities and rent. Next they give the employees a severance package and pay off vendors.

Then they start selling all their goodies. What could a manufacturer sell?

• Finished inventory
• Raw materials inventory
• Headquarters building
• Manufacturing building
• Manufacturing equipment
• Office equipment
• Accounts receivable
• Investments
• Patents or designs
• Brand name of the company or product lines

Let's turn that list into a list from the most liquid goody to the least liquid goody. Why don't you make up your list first and then check it against what I have below.

Why is raw materials inventory before finished goods inventory? Raw materials are more liquid because you can simply send them back to the vendor.

Why is office equipment before manufacturing equipment? Because there are more people in the world who would want to buy your office chair and desk than a custom widget-making machine.

Buildings are near the bottom of the list because they may take months, possibly years to sell depending on their desirability.

And intellectual property, such as patents and brand names, are even less liquid than buildings because any number of businesses might move into your building, but only a few people in the world would want to buy the brand name of your product lines . and even then, they may not want it at all.

So, as we are looking at this list, think of your own organization. Are most of their goodies at the top end of this list, or at the bottom end? If they are at the bottom end, your organization may not be very liquid.

Dell is very liquid. They have miniscule amounts tied up in intellectual property or real estate property. Many of their buildings are leased. They have $10 billion dollars in cash, minimize their receivables by asking their customers to use credit cards, and hold only three days worth of raw and finished good inventory. Their holdings are on the top end of the list.

Why is liquidity important to a company like Dell? Well, if the market changes, if a competitor act, Dell can easily respond. If all of its resources were tied up in intellectual property or real estate, it would have to let the opportunity pass.

So back to the scenario where we are liquidating our company: Now that we have paid everyone their severance pay, paid off our vendors, paid our last payments on utilities and rents, and sold off all our goodies, we should have a big pile of cash in our hands.

After Liquidating Our Assets, We Pay Off the Owners

Now it is time to pay off the owners with this money. This is the story that the right side of the balance sheet tells us. It tells us who owns the business. After we have paid off the vendors, or our accounts payable, we have three accounts to work with - debt, stock, and retained earnings:

So, in paying off the owners, whom do you think gets the money first?

The bank does. As part of the loan covenants, the bank stipulates that in case of liquidation, they get their money first.

Next - and finally - come the stockholders. Any funds that are left are carried off by the owners of the company. If, after paying off the bank only one dollar is left, the shareholders split the dollar and cry about their mediocre return.

Now what happens if the company doesn't even have enough cash to pay off the bank? This is called bankruptcy or rupturing the bank. In this case, the shareholders get nothing, and it usually means they have to dig into their own pockets to make up the difference to pay the bank. Banks don't often walk away from such a sad situation and passively let the shareholders hit the road. They will oftentimes pursue the owners for the remainder.

In Texas, we have a law called the Homestead Exemption Act that allows individuals to keep their house and a mule (in modern terms, a car) in case of bankruptcy. The bank can't touch these items. However, they can get to everything else; your coast house, your second car, your savings account, etc. So in the early 90s, when everyone in Texas was in such bad shape and folks were going bankrupt left and right, those under the counsel of a lawyer went out and bought a Mercedes and the best home they could afford before declaring bankruptcy. That kind of stuff doesn't play as well 15 years later. The banks are serious about getting their money back and work to find ways to pierce the "corporate veil" you may heard tell of to recover their investment.

So in pretending to liquidate, you can tell an interesting story about how the company is financed and where they invested their funds.

Looking at the balance sheet model again,

What kind of balance do you want to see in cash? A large balance or a tiny balance? Large!

What kind of balance do you want to see in receivables? Large or tiny? You want this number to be as lean as possible. A disproportionate balance may indicate that the company has a hard time collecting from its customers.

How about inventory? You prefer that the company have a minimal investment in inventory. If your resources are tied up in inventory, they aren't tied up in cash. which is where we want the majority of our resources, right? How about equipment and buildings? Again, minimal.

How about intellectual property? Again, mimimize if you can. Now, that is the key wording here . "if you can". Some industries are going to have heavy balances in some of the less liquid categories and can't help it. For instance, the airlines are going to have huge fixed asset or equipment balances and can't help it. Department stores may be forced to hold huge inventory balances and can't help it. (I feel it is important to point out here that industry leaders are often the ones to break the mold. Wal-Mart, the leader in retail, has minimized their inventory balances by holding their entire inventory on consignment.)

It is very important to know that you cannot compare a balance sheet between industries. You can't compare an airline's balance sheet with the balance sheet of a department store. The comparison is just not meaningful.

For comparison's sake, it is best to stay within the industry, but even that presents challenges as different businesses within the same industry have different business models. (More about that in later newsletters.)

Now looking at the other side of the balance sheet, what kind of balance do you want to see in debt? Right, you want it to be reasonable. You don't necessarily want to see zero debt. Debt can be a wonderful tool in many circumstances.

Again, back to your personal life. If you didn't have debt in terms of a home mortgage or a car loan, you couldn't live near enough to your job to get to work on time each morning. To live debt-free, you might have to live in the country in a trailer eating beanie-weenies every day . not a pretty picture. Oftentimes, debt allows a company to expand and take advantage of opportunities it might otherwise have to pass up. So some debt is fine, we just don't want the burden to be too much to handle.

On stock, the balance in this category is generally fixed at the price that the shareholders paid in for the stock on the first day of the company's inception. Occasionally, the company might issue more stock to finance growth or special projects.

Ideally, in a highly evolved company, the stock balance would be decreasing over time because the company was buying back its stock. This does several happy things. It increases the value of each remaining share of stock out on the market, because there are fewer shares in fewer hands, and it concentrates control of the company into fewer hands. You end up with fewer people telling you how to run your business.

Retained earnings, of course, should be a healthy number. However, if the company pays dividends, the shareholders may prefer that instead of retaining earnings in the company that the company distribute the wealth to them. So the ideal balance of retained earnings depends on the philosophy of the organization. They may prefer to share the wealth with the owners by paying dividends rather than keeping it inside the company to grow.

WHEW! That was a long story! Next month, we begin looking at the income statement - or as some call it, the P&L.