BALANCE SHEET LIQUIDITY RATIOS
Heart disease and resulting heart attacks is our number one killer. Most folks who have heart conditions or suffer heart attacks never know that anything is happening to them – until it’s too late. But a $40 blood pressure gauge and a simple blood test can tell them if they suffer from this condition and put them on the road to recovery.
Imagine for a moment that your business has a “heart condition” about which you are not aware. Some of our grandparents felt that if you don’t talk about it, it won’t happen. But we’re supposed to be smarter than that. We know that bad things can happen to perfectly good insurance agents – simply by their lack of attention. A few simple calculations made on your (accurate) balance sheet items can tell you whether you are healthy, getting sicker or getting better. You need to pay attention to these categories and measurements every month and take action to improve these critical issues before you find that you can’t pay your bills or make payroll without constant trips back to the bank (or your own bank account).
Just as the physical tests made for cholesterol or heart conditions, if there are false indicators in your balance sheet (mistakes and mislabeled entries that cloud the real measures) you must correct them (or your accountant can do so for you) before the liquidity ratios of your agency are properly cast. But once your balance sheet is correct, these liquidity ratios could virtually save your business.
Here are a few of the CRITICAL MEASUREMENTS that you can simply do, yourself, to gauge your own health:
1. Working Capital (WC) – This is the simplest (and one of the most important) measurements. Subtract Current Liabilities from Current Assets. This number defines your ability to pay your monthly bills (in the future) with your monthly cash and collectible commission receivables.
Working Capital reveals more about your financial condition than almost any other calculation. The more WC, the less financial strain a company experiences.
How much WC should you have? When we value agencies, we add value when agencies have more than 30 days of WC and subtract value if it has less than 30 days of WC. The rationale is that if you turned your agency over to another owner, he needs 30 days of cash (or cash equivalent) in the bank to pay his first month’s bills before he can start collecting commissions himself.
How do you judge how many days of WC you have? Take your last year-end Operating Statement and look at your total expenses. Subtract the ‘non-cash’ expenses that are reflected on the Operating Statement (like Depreciation and Amortization and Bad Debts) and divide by 365. That figure is one-day WC for your agency. You need 30 days minimum to be considered healthy.
O.K, now you know your WC and days of WC and you know you need 30 days to be healthy. So what does it mean if you either have 35 days worth of WC, 10 days of WC or if your Working Capital is actually a NEGATIVE number?
First, like blood pressure and blood tests for cholesterol, these measurements are only meaningful as trends. A Balance Sheet is a picture of your agency’s health ONLY AT ONE POINT IN TIME. So if you do a Balance Sheet calculation like WC and Days of WC, if you like what you see, do it every month and make sure the ratios and numbers hold up. If you don’t like what you see you can go back and run Balance Sheets for each of the last 12 months (or more) and see if the negative results were an anomaly or a trend. Then you can either take action or wait and continue to look at the measurements over the next several months to better define your WC trend.
If the WC or Days of WC is unacceptable, what do you do?? The most direct way of solving a WC deficiency is to improve your cash position and/or tighten your receivables position. Whether the cash position is improved by generating more income (selling more insurance) or collecting better on your receivables (all receivables should be collected by 60 days and 75% should be collected within 30 days) this would release more money to pay your normal bills each month. If you cannot increase cash or convert receivables, the next solution is reduction of cash expenses (a change of spending habits, not a one-time saving). Put your expenses in numerical order from the greatest to the smallest. You must look at compensation first since very few other expenses are controllable. Look at your own compensation and determine whether you can get along on less. If you are not selling insurance to permit revenue growth (and are suffering from the soft market like everyone else, reducing your cash and income from your existing business) you must also consider reduction in force. Nothing is permanent, including this market, but if you are running and growing a negative WC, you must react before you are bankrupt (can’t pay your carriers or make payroll) to keep your business going until the market hardens.
If you have more WC than you need, that’s great! Keep it up. That excess working capital is simply dollar-for-dollar increasing the value of your agency and gives you a cushion in the event that you have a hard month or two.
2. Acid Test – The Acid Test (also called the Quick Ratio) is an even more detailed measure of your ability to pay your carriers in the future. The formula is:
Acid Test = (Cash + Accounts Receivable)/ Accounts Payable.
This measure tests whether or not you will have enough money to pay your companies every month. Again, this test is best used on a regular basis to test the agency’s trend. Some advanced agencies actually project cash and receivables projections months in advance to judge their financial condition based on the flow of their business (considering low and high renewal months).
Unfortunately, many agencies around the country must use this month’s collected cash to pay last month’s payables. This works only until something bad happens – i.e. the loss of a major account that provided steady cash flow. Then the agency could collapse in one month if no further cash can be found to support carrier payables. The Acid Test will keep this from happening if you maintain a Trust Account to keep you from spending tomorrow’s money paying today’s bills. Many States require Trust Accounts (separating premium owed to the carriers from commission dollars available to pay your bills) but this practice is a very good one for every agency in the country.
We seek an Acid Test of 90% or better in healthy agencies.
The most disciplined way of “fixing” a poor Acid Test is to loan money to the agency to recover its cash position and pay that money back over time. Then you must maintain spending to a level that permits your receivables and cash (Trust Balance) to equal your payables at any point in time. Acid Test and Working Capital have close relationships, similar causes and similar solutions. Make sure your receivables are real and collectible (or convert to Direct Bill to simply avoid that issue) to maintain strong Acid Test results.
In the next issue we will address Trust Accounts and Receivables/Payables Ratio in more detail. If you need any help with these or any other analysis of your Balance Sheet, call David or Al Diamond at 800-779-2430 and we will lend any assistance we can to help you.