President's Message February 2008

It was the summer of 1990 and I was sitting in my office badly shaken. My bank had just told me Vanguard’s credit line was being canceled.

Sure, the economy was bad, but how could this be? How did we get into this situation? How was I going to pay the bank hundreds of thousands of dollars in less than 90 days? After all, I was a CPA and should have seen this coming, right?

This was a very humbling period in my career, and it taught me one very important lesson: The Balance Sheet Rules. Leading up to this event, my primary focus was to analyze our Profit and Loss statement each month and merely glance at our balance sheet. I could recite from memory our sales, gross margin and overhead figures for any given period. And of course, I knew what our commission costs were. But I wasn’t properly monitoring the balance sheet.

Why is the balance sheet so important? In simple terms, while the P&L statement reports your activity for a certain period, it doesn’t tell you where you stand overall. The balance sheet reports your financial condition as of a certain date.

In Vanguard’s case, we were reporting profits during that period in 1990, but our cash payments were consistently exceeding our cash receipts, putting us in a poor cash position. Additionally, we were accumulating large inventory balances of stock paper that were not moving. Further, we carried a large group of customers that were paying us well beyond terms. All of these factors created a serious negative cash position.

“By not keeping earnings in the company, it’s a double-edged sword. Not only do you not have funds for growth, you may not make it through a lengthy downturn in the economy.”

If I had been monitoring the balance sheet and a few generally accepted ratios, we would have seen this coming. Tim Murphy, Vanguard’s CFO since 1999, likes to look at a few key ratios and indicators monthly and quarterly when preparing his report to the owners of Vanguard. “The ‘quick ratio’ is a great ratio to calculate on a regular basis,” says Murphy, “because it’s a good gauge of your ability to service your current debt.” This ratio, which compares cash and receivables to current liabilities, is often used by banks that you may have a loan with. A good ratio, according to Murphy, is at least 1 to 1. Another similar calculation favored by banks is ensuring that cash and receivables exceed one year of loan payments.

“Cash flow is everything,” says Murphy. “If you are thinking of selling your company, many buyers will value your company based on the positive cash flow that your company generates.”

Other key ratios Murphy uses include the inventory turnover ratio and receivable turnover ratio. “Inventory and receivables are both potential black holes, says Murphy. “It’s critical that you monitor the movement of these areas, especially if you have significant inventory or carry large amounts of receivables. For instance, looking at ratios on a regular basis will send up warning signals when inventories are being stretched out or payments are slowing down.”

Building up retained earnings (net worth) is also vital for businesses that want to grow and sustain themselves. “Most of our businesses are changing,” says Murphy. “It’s difficult to keep up with change without reserves for reinvestment.”

Many company owners in our industry take each year’s profits out of the business. We have a sales mentality and are looking for the “big commission” at the end of the year. Murphy warns that this is a recipe for disaster. “By not keeping earnings in the company, it’s a double-edged sword. Not only do you not have funds for growth, you may not make it through a lengthy downturn in the economy.”

Truer words were never spoken. The end to the Vanguard story was a good one, but not without some painful decisions. After obtaining alternate financing at a much higher rate, we closed an office and terminated the jobs of several good people. Left with a committed staff and a “no frills” attitude, we struggled along for two years and improved our balance sheet enough to go back to traditional financing. Today, we closely monitor our balance sheet and strive to build up solid net worth.

It’s no coincidence that we are talking about this today, during the first economic downturn in many years. Many of us have never been through this with our businesses. “Stay close to your accountants and financial advisors during this period,” warns Murphy, a firm believer in Murphy’s Law: What can go wrong, will go wrong. “In a bad economy,” he says, “there is a trickle-down effect resulting in negative occurrences in all areas of finance.”