A Question of Balance…Sheet

Nearly 50 years ago the English rock group Moody Blues released their album, “A Question of Balance”. The lyrics to the title track were typical of music of the time and not particularly relevant to analyzing a financial meltdown. But it might encourage some soul searching for ways to navigate a very difficult period. Especially when it comes to the Balance Sheet.

The last two months have been exceptionally instructive on several levels. A buoyant economy, historically low unemployment, and low interest rates made us all look smart. Cash flow ruled. For the most part, it lifted all commercial portfolios. We told ourselves that the good times would come to an end at some point. However, I am not sure anyone among us could have predicted that an unseen virus from the other side of the globe would stop a barreling economy in its tracks in a matter of weeks. Yet, that is precisely what occurred. The U.S. equities market lost $11.5 trillion in market cap from the high on February 19 to March 12. The labor force went from a position of more jobs than workers (April 23, 2020 Fortune Magazine article). Now it went to a loss of 26.5 million jobs and unemployment in excess of 20%.

As lending and credit professionals, what is a prudent course of action? Our recommendation is to get back to the basics. Focus on the consistent 5 C’s of credit: Character, Cash Flow, Financial Condition, Collateral and general Economic Condition. Since none of you want a primer on all five, we will restrict the discussion to two (well, mostly one!).

Understanding the Balance Sheet

It has been said that “cash is king”. If that is true, then financial condition, as represented by the company balance sheet, is the queen. Cash flow can put food on the table, a car in the garage and a roof over your head. But the balance sheet is all about weathering a storm; and we are certainly in one now. There are many instances where the focus of the credit review will change from “cash flow” to “cash burn”. That means understanding the balance sheet.

When we think of balance sheet condition, we are not focused exclusively on net worth or leverage, but rather on how much cash a borrower/business can wring out of the assets and over what period of time. Lower revenues mean less purchases and payroll. How much of the existing inventory can be converted to profitable sales without new purchases? As accounts receivable collect and inventory declines, cash is generated, and less cash is needed for working capital.

Asset Values

And what about asset values? How do book values compare to liquidation values? A thorough scrubbing of accounts receivable for collectability, an honest review of inventory for marketability (as well as timing of that marketability), true value of other assets including investments and/or subsidiaries, officer and owner receivables, and finally any “hidden equity” in real estate and/or machinery and equipment is of critical importance. The review of long-term assets may uncover potential value for obtaining cash for operations, renegotiate existing debt terms or just identifying assets that can be liquidated for cash.

Liabilities

A similar thorough analysis is critical on the liability side as well. Understanding all debt holders, and the terms and conditions, from trade creditors to the bank to officer/owner, and the respective terms (secured, unsecured, interest only, amortizing, etc.) is essential for developing a plan to conserve cash outflows while preparing for a return to “normal” operations. Liabilities need to include both on balance sheet as well as potential off balance sheet obligations such as leases or non-compete payments.

Many financial institutions are in the midst of the very busy annual review season. Because of the heady economic times that the general economy is experiencing, financial institutions stretched their normal credit parameters. Much of this stretch was in the form of leveraged lending or highly leveraged transactions. As discussed in our March 2020 blog “Get Ready, Get Set, Go”, regulators were sounding cautionary alarms. This was as they were observing many loans characterized by weak credit structure and weak covenant packages. These findings are relatively typical after a sustained period of strong economic performance.

How To Evaluate Credit Risks Now?

However, this also leads to potential issues in our annual review processes and credit risk evaluations. In our February 2019 blog, “Driving with the Rearview Mirror”, we discussed the tendency of bankers and financial types to spend most of their time looking in the rearview mirror (past performance) as a predictor of future performance. This is going to be a real danger when we look at year-end 2019 performance in view of the dramatic fall in March and April of 2020. As well as not knowing when the situation will reverse. The risk rating matrix is looking backwards. This will generate a risk rating score that is very strong, but your borrower may be meeting with their bankruptcy lawyer. The discipline of obtaining current interim financial statements and monthly projections as part of the annual review and risk rating analysis will be of critical importance.

Maybe the Moody Blues had it right 50 years ago about “a question of balance”. We are certainly experiencing moody blues in our financial world now and a thorough understanding of the balance (sheet) may be more critical than ever.

Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape, and lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call: 920.445.8133