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Liquidity Traps to Avoid

“Gazintas”? What is that? “Gazinta” is what I call a “goes into” and your balance sheet is full of them. Your balance sheet is dynamic, not static, and a “gazinta” indicates a change in your balance sheet and the reason. Cash going down “goes into” receivables going up or purchasing equipment for cash or funding losses in your business. 

I have several clients that love to bill work, but would prefer not to collect it. One has had great billings for the first quarter. But their receivables have ballooned up to 81 days from 60 days historically. Another client believes they shouldn’t ever borrow money. So, they pay cash for equipment. Another client has made significant investments in marketing expenses, but didn’t slow down their distributions. All of these circumstances “go into” a decline in liquidity. I call those liquidity traps. To avoid liquidity traps, I always suggest having a line of credit to replace the cash lost by these circumstances. For equipment, get a term loan. 

There are several key performance indicators that can monitor liquidity. My “go to” is day sales in cash. You can calculate this by taking your sales/day (annual revenue divided by 360 days) and then dividing your cash balance by that number. For example, if you have $200,000 in cash and your sales/day is $20,000, then you have 10 days sales in cash. Cash is like oxygen for your business, 5 days sales in cash and you may be hyperventilating. 30 days, you’re probably breathing easily.  

The next “gazinta” is that debt goes up if you fund losses with it, borrow money to purchase fixed assets, or take distributions more than profits. I had a client who took excessive distributions and then borrowed money against receivables to fund payroll. I’ve also had several clients in startup mode that have borrowed money to fund losses rather than put the money in themselves. Leverage is ok if used in moderation. Leverage magnifies gains and losses. So, a profitable business benefits from borrowing. An unprofitable business runs the risk of making losses worse because cash from profits or from liquidating assets is required to pay the interest expense and the principal. 

I use one key performance indicator to monitor leverage, the debt to worth ratio. Take total liabilities divided by total net worth. If your total debt is $1 million and your total net worth is $400,000, your debt to worth ratio is 2.5:1. I recommend you consider a debt to worth ratio of 3:1. Above that, many banks will say no to a loan request or express concern. 

Many business owners struggle to interpret their balance sheet and make changes to improve liquidity and leverage. Our balance sheet is more important than our income statement because it measures liquidity and leverage, not just profitability. You can’t manage what you don’t measure. So, if you haven’t started keeping score on your liquidity (cash and collections) and your leverage (debt/worth), start today and keep score monthly. 

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