The word “debt” is rarely expressed as a positive notion. Financial advisors coach clients to reduce financial liabilities. Politicians push to eliminate the federal deficit. College graduates bemoan daunting student bank loans. Debt is a four-letter word. That is both an absolute fact and a matter of perception.
When the same concept is called “leverage,” wealthy people and business executives see potential. Using other people’s money for the purpose of acquiring an asset or funding business growth can be an effective financial management tool for those who can afford the risk and are able to repay the obligation.
Let’s go over a few key principles to financing:
Funding should be matched to the useful life of an asset.
Debt is a prudent way to fund an appreciating asset, but a dangerous way to finance a depreciating asset.
Equity is the most expensive form of financing.
As an advisory firm starts to operate more like a business, owners must learn how to use and manage the balance sheet. This helpful tool provides great insight.
The balance sheet tells you what you own (assets) and how you fund it (debt and equity). It organizes your assets top down, from the most liquid to the least liquid. It illustrates how you are financing your business from short-term commitments to the most permanent. When transformed into key ratios, the balance sheet informs you of your ability to pay your bills and your ability to withstand adversity.
Key Balance Sheet Ratios:
Current Ratio = Current Assets ÷ Current Liabilities (The higher the ratio, the more liquid the company.)
Debt/Equity Ratio = Total Liabilities ÷ Total Equity (The higher the ratio, the more at risk the business.)
Managing the Balance Sheet
Important dynamics within advisory firms make balance sheet management critical.
As advisory firms grow, a gap can occur between when services are rendered and when fees are paid. Advisors typically receive payment in advance when they assess the client’s portfolio; a fee based on assets under management. This fee covers one quarter of service and must last until the next billing cycle.
The firm must pay its staff, plus cover rent, utilities, marketing and other overhead. When recording transactions on the balance sheet, prepayments appear as “cash” on the asset side of the balance sheet. Much of the same payment also appears as a liability because it represents an obligation to provide advisory services for the quarter to come.
The prepayment is drawn down throughout the quarter as expenses become due. Then the cycle begins all over again the next quarter. If the cash on hand is not sufficient to meet the firm’s obligations during a quarter, the advisor likely borrows from a line of credit, thus increasing the short-term (current) liability. Without careful management, current liabilities could exceed current assets, diminishing the working capital of the business.
The working capital challenge is exacerbated when a business uses short-term debt to fund long-term needs. A common principle in financing holds that funding should match the useful life of an asset.
Advisors have been trained to stay out of debt, so using a short-term line of credit makes them feel that they will get out of hock more quickly. They fail to appreciate — especially when the business is growing — that using short-term capital to fund a long-term asset puts stress on their cash flow and possibly sets the stage for refinancing or seeking new funding.
The balance sheet works better when advisory firms contemplate mergers and acquisitions. Some private equity firms are attracted to the financial advice business as a way to generate a return for their investors. Private investors are also steering millions of dollars into digital startups in hopes of capturing the generational shift to robo solutions.