During the great tech boom, financial advisers were making money without even trying. Many got caught up in this high-flying frenzy of cigar and cognac parties and elaborate client-appreciation galas.
Although these firms were producing profits, they were also con- suming cash, much of it in excess staff and infrastructure. A number of advisers saw debt as a useful tool for leveraging growth. Some used it to initiate practice-acquisition programs, introduce new ser- vice lines, or build fancy offices.
As the market began its decline, the balance-sheet vice began tightening its grip on advisers. In one case, a bank asked us to help an advisory firm restructure and reorganize so that it could meet its obligations. The bank had a referral relationship with this advisory firm, as well as a lending relationship. Although the financial loss to the bank would have been considerable if the firm folded, the embarrassment to everyone involved might have been even worse.
The bank required a personal guaranty on its loan to the adviser, but unfortunately for both parties, most of the adviser’s assets were tied up in equity investments, which had also seen a precipitous decline.
The owner-adviser was quite resentful of our being called in, perhaps because of the personal humiliation but more likely because of his fundamental belief that he could sell himself out of
FIGURE 9.6 Evaluating Owner’s Returns
Revenue – Direct expense
= GROSS PROFIT – Operating expenses
= OPERATING PROFIT
Return on labor
Return on ownership
the problem. But the bank had its own regulatory and policy prob- lems and could not let the adviser slip any further into debt. The adviser already owed more than $500,000 and had zero equity in the practice; cash flow was slowing and there were no assets avail- able to pay down the loan.
Our analysis uncovered a surprising situation—and probably one that resulted from the special relationship the adviser had with the bank president. All of the firm’s debt was in the form of a line of credit, which, according to the bank’s terms, had to be unused, or “rested,” for thirty days. In what was once a common practice, banks would authorize a line of credit tied to something like accounts receivable, and it would be available to fund short- term needs. Banks often looked at service businesses as seasonal, so they would assume that there would be a spike in borrowing as cash got tight, then a repayment of the line when the business was flush again. Like many advisory firms, this one assessed fees to its clients quarterly, and so it too experienced the ebb and flow of cash throughout the year. In this case, a market decline in asset values materially affected cash flow.
More distressing than the declining cash flow, however, was the use of the credit line. It appears that this owner-adviser was not buy- ing the pessimistic adage that what goes up must come down. An undying optimist, he saw the bear market as a tremendous opportu- nity to expand and did so with new offices and the buyout of another practice, all using cash from his line of credit. In the course of our negotiations, we were able to persuade the bank to stretch the amor- tization of most of the loan to five years in return for persuading the adviser to drastically reduce his overhead, including subletting a portion of his office space. The pain for the owner was great, but the restructuring worked and everyone came out whole—although it took several years before the adviser was back to an income level that supported his lifestyle.
The moral of this story reinforces the need to understand the power of financial leverage. Debt can be a great technique for gearing up growth, but it carries more risk in a service business, especially when it’s structured wrong and based on a bad set of assumptions.
And this mistake may be more common than people suspect.
Although many financial advisers believe that most people in this business do not borrow to fund their operations, in our studies and consultations with advisers, we’ve found that not to be true. What is true is that many advisers simply do not have a balance sheet to monitor how they’re managing assets and liabilities and, as a result, run the risk of hitting a wall. A balance sheet tells you about two things: solvency, a firm’s ability to pay its bills; and safety, its ability to withstand adversity.
Solvency
Solvency is measured by comparing current assets to current liabili- ties, or assets that turn to cash in one year or less versus bills due in one year or less. Obviously, you always want current assets to be larger than current liabilities. By dividing current liabilities into current assets, you arrive at the current ratio. The ratio is usually expressed as a number—for example, $100,000 ÷ $50,000 = 2. This means that for every $1 of current liabilities, you have $2 of current assets. If the ratio were 0.75:1 (that is, $75,000 ÷ $100,000 = 0.75), that would mean you have $0.75 of current assets for every $1 of current liabilities.
It’s best to observe this number over the course of three to five years so that you can see if there is a trend. If the number is declin- ing, you should be aware of that. If the ratio is under 1:1, you should be worried, because it means you do not have enough current assets to cover your short-term obligations. In a distribution business, for example, it’s common for companies to use a combination of long- and short-term debt. They use the short-term debt (current liabilities) to replace the cash that’s tied up in accounts receivable and inventory (both current assets). When they turn over their inventory and collect on their receivables, they produce cash, which they use to pay off the short-term debt.
A financial-advisory firm can apply the same leverage, but it’s important to recognize that these firms typically don’t have much in current assets. Some practices have accounts receivable and also track work in process, which could convert to cash to pay off this debt. But if the firm has neither, then it runs the risk of increasing its obligations and not having a means to repay them, unless the
owner is willing to dig into his own pocket to pay them off.
The most common reason financial-advisory firms find them- selves in a solvency squeeze is that they use short-term debt as if it were a line of credit to finance fixed assets. In the balance sheet in Figure 9.7, the fixed-asset line is increasing as the current liability line is dropping. The space in the middle—the net work- ing capital—is shrinking.
The solvency squeeze occurs most frequently when a business is growing. You decide you need new office space, so you structure a new lease with more space. As part of the move, you invest in lease- hold improvements to make the space appealing, and you add new furniture, fixtures, and equipment. All of these are fixed assets that need to be funded.
If you use your line of credit to purchase these fixed assets, you deplete your working capital, which you may need for critical operat- ing expenses such as meeting payroll, settling your accounts payable to vendors, or paying quarterly taxes. A line of credit is a funding instrument designed to help a business finance its short-term operat- ing needs, not its long-term assets. If you use up your line of credit
FIGURE 9.7 Balance Sheet
Current assets
Fixed assets
Current liabilities
Long-term debt
Equity
Net working
capital
Source: © Moss Adams LLP
by financing the wrong type of asset, you’ll have nothing left to fund your short-term obligations.
The rule of financing is to match funding to the useful life of an asset. Long-term assets should be financed using long-term debt or equity. Short-term assets are financed using all three components—
current liabilities, long-term debt, and equity. Although dipping into the credit line temporarily to purchase a long-term asset may be expedient, a lack of discipline often gets service businesses into trouble. It’s a little like the client who can’t stay away from the ATM machine, despite your warnings.
Safety
Safety is measured by dividing total equity into total liabilities. This is called the debt-to-equity ratio. The bigger the number, the more concerned you should be. Again, watch the trend over a period of time; don’t just look at the number in isolation. The ratio is best expressed as follows: total debt of $100,000 divided by total equity of $50,000 = a debt-to-equity ratio of 2:1. This means you have $2 of total debt for every $1 of equity.
Most advisory firms have a debt-to-equity ratio under 1:1. When the ratio exceeds 1.5:1, there is cause for concern. Financial lever- age in a service business is a very risky proposition because it usually does not have the right types of assets to fall back on to pay off this obligation. In liquidation or distress, accounts receivable and work in process get discounted to virtually nothing and fixed assets attract only a few cents on the dollar.
There are times when using debt to fund an increase in fixed assets or current assets can help accelerate the growth of the busi- ness. That should be the driving force of any borrowing you do.
Obviously, if debt is used because you’ve been recording operating losses and have no money to fund your assets, you’ll be entering a dangerous cycle.
So how do you decide when it’s okay to use debt to fund growth?
The principle of financial leverage is that you use debt to fund assets, which then translates into greater profitability. In a retail business, for example, the store owner will use a line of credit to purchase inventory. Once sold, the cash is used to pay down the line. In a
manufacturing business, a company will use a term loan to purchase equipment that will allow it to produce its products more efficiently or in a way that helps it achieve or maintain its profitability. A finan- cial-services business might invest in leasehold improvements, com- puters, or high-speed color printers and scanners, all with an eye toward enhancing the perception that it’s a successful business. But will the purchase result in more business, higher-margin business, or better productivity?
Advisory firms get into trouble when they use debt to fund losses.
In other words, they run out of working capital and need to pay their rent or some other expense, so they dip into their credit line. Since the borrowing is not funding an asset that helps produce profits, such a firm often finds itself in a pickle when the need to borrow occurs in every pay cycle. Having no profits means it has been unable to retain earnings to fund its growth. More debt puts an additional strain on profitability. And the cycle continues.
The Origins of Equity
When a practice grows, both its income statement and balance sheet grow with it. If the asset side of the balance sheet is growing, then the owner must use a combination of debt and equity to fund it. But equity can come from only one of two places: new capital or retained earnings.
Advisers rarely retain earnings in their practices, so to fund the increasing balance sheet, the owners of the practice might do a capital call to inject new equity into the business, or they may lend money to the business. In the eyes of a banker, by the way, a share- holder loan is treated the same as equity because it’s assumed that the money will never be repaid.
If you’re the owner of a small, solo practice, it’s easy to put money in and take money out of the equity account, because you’re accountable only to yourself. But if you’re part of a larger practice with multiple stakeholders, you may find that some of your partners do not have the financial wherewithal to participate in capital calls.
This puts a burden on the wealthiest shareholders and creates unnec- essary conflict. So as the practice grows, begin to project your equity needs and retain earnings appropriately so that you will not have to
go back to the shareholders to ask for a loan or infusion of cash for the business.
Use debt to fund the balance sheet, not to cover losses on the income statement. Recognize the principle of financial leverage, whereby debt is used to finance assets to help you produce a profit.
In addition, match funding to the useful life of an asset. Be careful about using short-term lines of credit to finance long-term needs.
Recognize that equity can come from only two sources and that, for both emotional and financial reasons, it’s prudent to retain some earnings in your business to help fund your growth.