Our bank put us on notice that our balance sheet measurements as of the end of last year are no longer adequate to support our loan. They are bothered that our debt-to-worth ratio is 3 to 1, and our current ratio is 1 to 1. As a result, the bank warns that it will be reducing our line of credit limit and requiring the personal guarantees of our two major principals. We use our line of credit to even out cash flow and can’t afford to have our limit reduced. What should we know about balance sheet measurements? What can we do about this?
A balance sheet is one of two principle financial statements, the other being an operating statement (profit and loss statement). A balance sheet reflects the capital structure of a firm (what you own and what you owe). An operating statement tracks the flow of income and expenses.
Often formatted as two side-by-side columns, a balance sheet gets its name because the dollar total at the bottom of the left and the right columns must be exactly equal for it to “balance.” Assets are recorded at their accounting values on the left, and liabilities and owner’s equity (net worth or book value) on the right. Bookkeeping adjustments are made each month adjusting the amounts recorded on the balance sheet to reflect their then current accounting values.
The message the balance sheet offers is this: If all the assets were sold for the value reflected as of the date of that particular report, and all the liabilities were paid off from the proceeds of the asset sales, the amount remaining would be left over to distribute to the firm’s owners (owner’s equity). Stated as a formula, assets minus liabilities equals owner’s equity.
The debt-to-worth ratio is the traditional measure used for assessing the financial stability and risk inherent in an organization. The debt-to-worth ratio comes from dividing a firm’s total liabilities by its owners’ equity. A debt-to-worth ratio of 3 to 1 means that the creditors have $3 invested (at stake) in support of the firm’s assets for every $1 of investment by the owners. The higher the ratio, the more “leveraged” a firm is said to be. The more leveraged the firm is, the more disproportionate the risk for lenders and other creditors to maintain or extend additional credit to the firm. Published surveys of financial statistics find that the median debt-to-worth ratio for engineering and architectural firms is consistently around 1 to 1, which is actually quite benign and healthy.
The current ratio is found by dividing current assets by current liabilities. A current asset is cash and other assets such as accounts receivable and work in progress that one would ordinarily expect to convert to cash within the coming 12-month period. The single largest current asset usually held by professional firms is accounts receivable. Similar in definition to a current asset, a current liability is any obligation that will be due and payable within the same 12-month period.
A current ratio of 1 to 1 indicates that for every $1 of debt coming due during the next 12 months, there should be $1 of cash on hand to meet that obligation. The greater the current ratio, the more “liquid” or “covered” a firm is said to be. At 1 to 1, there is no cushion or margin for error, which would lead a creditor to anticipate that your firm may be likely to experience problems from time to time meeting cash payment obligations as they come due. Surveys report the median current ratio for engineers and architects to be around 2 to 1.
To allow your banker to feel better about your relationship, work toward accumulating additional capital within your firm. There are basically two ways to accomplish this. The first approach is to hold back a larger portion of profits as retained earnings. Retained earnings add directly to owner’s equity and help reduce the firm’s reliance on debt to support operations. The second basic way to raise capital is to sell additional stock (or ownership) positions to willing investors.
Finally, when you do go to discuss your balance sheet and loan arrangements with your banker, never go alone unless you’re very knowledgeable in these matters. Take along your firm’s outside accountant or attorney to help you negotiate. Signing personal guarantees allows the bank to collect from guarantors, as well as the firm, in the event of a business reversal. Guarantees should only be considered as an extreme, last-choice option. If the bank still insists on reducing your credit limit, or remains adamant about personal guarantees, get the bank to commit up front what specific future financial conditions need to be reached to release you from the guarantees and raise back your limits.
David Wahby is president of Wahby & Associates (www.wahby.com), a management consulting firm serving A/E clients. He can be reached at 616-977-9756 or via e-mail at firstname.lastname@example.org. Get answers to your questions about design firm and project management, finances, marketing, international engineering, and related topics by sending them to email@example.com; reference “Business Q&A.” Include your name and telephone number in all correspondence. Your name will not be used in connection with published questions.