Lane Cardwell

The Year of the Balance Sheet

The Chinese calendar names each of the 12 years after an animal. The Chinese believe the animal ruling the year in which a person is born has a profound influence on personality, saying "This is the animal that hides in your heart." Each animal repeats every 12 years. 2005 was the Year of the Rooster. 2006 was the Year of the Dog. 2007 was the Year of the Boar. And wouldn't you just know it, 2008 was the Year of the Rat. As true as that must sound, I believe that the Chinese should make an exception this year and rename 2008 the Year of the Balance Sheet.

More attention has been paid this year to the balance sheet by the media, companies, investors, suppliers, and even employees, than I can ever remember. Debt and sliding sales have caused that shift. Public companies are beginning to include information on their financial releases about balance sheet derived data. You hear in the investor quarterly conferences by public companies such financial terms as "fixed charge coverage ratio" and "debt to cash flow ratio" and "adjusted leverage ratio". Somehow this just doesn't capture the imagination like "sales" or "cost of sales" or "net profit".

Let's face it. Balance sheets are boring. The very fact that they balance removes a lot of the mystery from examining their contents. Assets equal liabilities (unless you are the government). At least the income statement can end with a negative number. Now that is a cliffhanger. You never know with an income statement exactly what you are going to find until you look at it. The balance sheet has all of the sex appeal of a math textbook. The income statement is an entertaining book, just hopefully not a novel.

The income statement belongs to all employees, especially the operators in a company, and is referred to constantly. The income statement is where the action is.  Sales went up or down?  Find it on the income statement.  Some costs went up, some went down? Find it on the income statement. When a company issues a press release to announce quarterly financial results it almost always quotes information found on, or derived from, the income statement.

Companies talk about sales being up or profits being up. They don't brag about assets being up, or liabilities being down. But in the Year of the Balance Sheet, the world has changed. The focus now is on safety, not sales. Comps used to be the only number that mattered to a lot of investors.  If you had positive comp sales, you probably had gains in profits. Now with an almost industry wide sales slump, except for many of those lucky QSR concepts, the investment community and the banks that loan money want to know that the debt can be repaid, and that a company can honor its loan covenants.

When a company borrows money, it agrees to certain things about the financial health of the company in the future. Levels of profitability and cash flow relative to the amount of debt are the most common. There are lots of add-backs and exclusions in defining profitability and debt, but basically the bank is requiring the borrower to maintain a certain margin of safety in their ability to repay the debt. When these promises aren't kept, when profitability drops below a certain agreed upon level, a loan covenant (a promise) is violated and penalties are applied. These penalties can include a dramatic increase in the interest rate that a company pays, restrictions on how a company can use its cash in the future, and so on. Violating a loan covenant costs a company money, and can even result in the loan being called in. Consequently, the amount of debt that companies have on the balance sheet, and their ability to repay it, is receiving unprecedented scrutiny. In many cases it is why a company's stock is moving up or down.

So now the balance sheet is having its day in the sun. With any luck it won't be a long day in the sun and we can go back to our love affair with the income statement. 2009 is the Year of the Ox, a building year when we begin to get our financial affairs back in order and the customer back in our seats. Which will reward us in 2010, the Year of the Tiger. But in the meantime, as we wind down 2008, we are living in the Year of the Balance Sheet.

Posted by Lane Cardwell on December 19, 2008 | Comments (4)