Roughly half of CFOs believe an economic recession will hit by the end of 2020, and about three-quarters expect a recession by mid-2021, according to the 2019 year-end Duke University/CFO Global Business Outlook survey. In light of these bearish predictions, many businesses are currently planning for the next recession. Are you? Here are four steps to help your company strengthen its balance sheet against a possible downturn.
1. Identify what’s most important
The balance sheet shows your company’s financial condition — its assets vs. liabilities — at a specific point in time. Some line items are more critical to your success than others. For example, inventory is a top priority for retailers, and accounts receivable is important to professional service firms.
A “common-sized” balance sheet can help you determine what’s most relevant. This type of statement presents each account as a percentage of total assets. Items that represent the highest percentages are generally the ones that warrant the most attention.
2. Analyze ratios
Ratios compare line items on your company’s financial statements. They may be grouped into four categories: 1) profitability, 2) solvency, 3) asset management, and 4) leverage. While profitability ratios focus on the income statement, the others assess items on the balance sheet.
For example, the current ratio (current assets ÷ current liabilities) is a solvency measure that helps assess whether your company has enough current assets to meet current obligations over the short run. Conversely, the days-in-receivables ratio (accounts receivable ÷ annual sales × 365 days) is an asset management ratio that gauges how efficiently you’re collecting receivables. And the debt-to-equity ratio (interest-bearing debt ÷ equity) focuses on your company’s use of debt vs. equity to finance growth.
3. Set goals
The common-sized balance sheet and ratios can be used to create “goals” for each key line item. What’s right depends on the nature of your business and industry benchmarks.
For example, you may strive to meet the following goals over the next year:
- Increase cash as a percentage of total assets from 5% to 15%,
- Improve the current ratio from 1.1 to 1.2,
- Decrease the days-in-receivable ratio from 40 to 35 days, and
- Lower the debt-to-equity ratios from 5.6 to 4.
4. Forecast the impact
Once you’ve set goals, devise a plan to achieve them. For example, you might cut fixed costs or forgo buying equipment to build up your cash reserves. In turn, stockpiling cash — along with improving collections — might help boost your current ratio.
Part of your plan should be forecasting how the changes will filter through the financial statements. This exercise can help you determine whether your goals are realistic. For example, if you decide to build up cash reserves, it might be difficult to simultaneously pay down debt. You can generate only a limited amount of incremental cash in a year. Forecasting can help pinpoint the shortcomings of your plans.
We can help
Markets are cyclical. So, it’s only a matter of time before another downturn happens. We can help you take steps to position your organization to weather the next storm — whenever it arrives.
Please reach out to your trusted Smolin professional with any questions or concerns.