If you have not seen The Big Short yet, I highly suggest that you do. In a nutshell, The Big Short is the story of how only a few individuals were paying attention when our rising economy was driven by a housing market propped up on bad loans. The few individuals who took the time to analyze the data eventually won their bet on the US economy’s collapse in 2008. The effects are still lingering.
Complicated financial instruments such as Credit Default Swaps (CDSs) and Collateralized Debt Obligations (CDOs), fueled by strong financial incentives, opaque financial reporting and poor regulation, allowed unsuspecting investors and home owners to build up expectations on a house of cards. As long as people thought they were making money, they were happy and no one paid attention. When the bubble eventually popped, cash was nowhere to be found and the bottom dropped. The rest, as we all know, is history.
Simple Lessons Matter Most in Uncertain Times
At one point this month, the stock market lost $1 Trillion US dollars. As we end a most volatile and weak month on Wall Street and as China, crude oil and the US dollar fuel uncertainty, it is time to pause on important lessons of still recent history. In the The Big Short, Michael Lewis reminds us of a simple yet important lesson for SMART Business Growth: Pay attention to your balance sheet.
5 Reasons Why You Should Always Analyze your Balance Sheet
- Your creditors care
- The balance sheet keeps your income statement honest
- Cash never lies
- You cannot grow on a foundation with cracks
- The balance sheet keeps you grounded
5 Key Facts from Comparing Balance Sheets
- How much cash you are accruing or burning
- How much of an asset base you have to grow
- How much of your assets are owned by creditors
- How much cash inventory and receivables are consuming
- How much equity you have built or consumed over time
The Balance Sheet Keeps You Honest
Cash is the fuel for growth. Ultimately, true revenue must be monetized, converted to cash. A company’s profit is only as good as the quality of its assets. Its long-term viability is only as good as its ability to “generate” cash. Just as subprime mortgages created a house of cards that people chose to ignore, the quality of your balance sheet is the foundation. If you do not collect your sales quickly enough, if you do not turn your inventory quickly enough, if you commit to recurring costs that you cannot handle or if you do not build equity as you grow, your balance sheet will show those cracks.
The Big Short teaches us that when you grow on debt that you cannot afford, eventually the cracks show. It is not a question of whether or not the bottom drops, but when. Growing strategically involves growing with informative systems, knowing your capacity and fuel consumption and financing growth through earned equity. You cannot control the economy but you can control how well you are prepared, how strong you make your foundation and choose to grow true revenue and true profits.
Examples of the opposite abound. On a smaller but still large scale, tales of Enron, Eastman Kodak and Radio Shack, though each very different, also remind us how the evolution of their balance sheet showed the cracks in the foundation. Enron created false revenue that was not monetized and consumed cash compensation. In the end, Eastman Kodak sold its patents and tried to disguise it as regular cash from operations. While Radio Shack’s inventory kept increasing, its sales and ability to grow equity kept decreasing. In all of these cases, borrowing kept fueling growth or provided a false life line until the bottom fell.
The Sign is on the Wall – Pay Attention
Ultimately, your balance sheet tells you if you are truly growing, accruing equity as you grow your asset base and how you are growing. Comparing your balance sheet over time also tells you how much fuel, “cash” you have and how much fuel your working capital (receivables, inventory, capital assets) is consuming or able to generate.
The Big Short highlights how economic growth was built on a house of cards and how most everyone chose to not look at the house of cards. While opaque financial reporting and poor monitoring allowed this to happen, you have access to your data and to your assets. You can look at the quality of your assets and you can validate whether the data is telling the story of your business and look ahead. More importantly, you can manage and build that growth on a solid financial foundation.
Call to Action
- What’s in your balance sheet?
