No, this isn’t going to be about Equity as in DEI (Diversity, Equity, Inclusion). This is about balance sheet equity. And if you run a business, you had better know what your equity (also known as “net worth”) number is and understand what causes it to move up and down. In fact, if you run a household (even if only of one) you had better know the same. Whether you produce a balance sheet or not (seriously, I once had a client tell me they didn’t have a balance sheet), equity is a key metric. At the end of the day (apologies for the tired cliché) absolutely everyone needs to understand their equity or net worth. Some other time, perhaps I’ll do a piece on financial literacy. To roughly paraphrase Ross Perot (I could not find the quote), everyone understands sports in this country and too few understand business.
Balance sheet equity is the difference between what you own (assets) and what you owe (liabilities). But more than that, it is the cumulative sum of the amount invested in the business since inception plus all profits less all distributions. Typically, the second piece of data I look at when talking with a potential new client is at the equity section of their balance sheet. My first glance is at the income statements to see if they have been profitable for the last several years.
Equity is measured at point in time and moves with the addition of profits and capital additions (issuance of company stock or sale from treasury) and the subtractions of distributions or dividends. In the case of flow through tax entities, there are usually distributions to pay taxes as well as additional distributions based upon profitability (at least that’s the theory). There are times when distributions are based not on profit but on owners’ lifestyle (that’s a poor methodology). On more than one occasion, I have seen businesses being decapitalized with little thought as to the consequences.
Usually, when a business owner tells me they have cash flow problems, negative equity is a big part of the problem. In these cases, the company is being financed by some combination of third party debt and vendor payables which are typically beyond agreed upon terms.
Other root causes tend to be excess inventory or rapid growth which is stretched beyond a company’s sustainable growth rate. Of the hundreds of businesses I’ve studied, I’ve only seen one that had negative equity and not have cash flow issues and that was solely because they got paid before they delivered the service (their customers funded their growth).
Banks often have a tangible (which strips out intangibles such as goodwill) net worth requirement as part of their loan agreements. This is because bankers understand the importance of maintaining a strong balance sheet to the health of the business and how it is related to the business’s ability to repay bank debt.
Take a look at your equity number. Go ahead, I’ll wait . . .
If your business could benefit from fractional CFO services, I would welcome the chance to speak with you. Please give me a call at (314) 863-6637 or send an email to [email protected]
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your cash is flowing. know where.®
Ken Homza
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