Accounting: Feeling good – does your balance sheet add up?

One of the key lessons from the credit crisis and the recession is the need for finance directors to put their focus back on the balance sheet ­ a point elegantly made by Richard Meddings, group FD of Standard Chartered, in his keynote speech at our annual bash, the Financial Director Summit, in September.

Meddings gave us his big picture view on where the FD needs to be. Sounds simple enough: get the balance sheet right, he said, and the profit and loss account will follow.

His view was that, over the last few years, FDs had become bogged down in P &L management and had neglected to put the right foundations for the business in place.

The FD’s focus on driving P&L performance meant, in his mind, that the balance sheet had been rather ignored. The consequence of this neglect is that, when the credit crisis and economic downturn pitched up, companies weren’t in the best shape they could have been to withstand the chill winds. The principles of building a strong balance sheet are not complicated. But the shape of a strong balance sheet will depend on the sector in which the company operates and the risk appetite, which although universally diminished, will still vary from enterprise to enterprise.

Meddings is right: a renewed emphasis on the balance sheet is long overdue. While it could be argued that its emasculation comes partly from the attention that has been diverted away from it, it is also true that at the height of a flourishing economy and a long period of easy credit, FDs were actively encouraged to reshape their balance sheet.

The idea put forward by Meddings is really a fundamental realignment away from some of the thinking that grew up in the days when it seemed the deluge of liquidity would be with us for ever.

It is easy to be a contrarian these days. But you can’t ignore the fact that Meddings has been a key player in one of the only banks recognised as having avoided the worst of the credit crunch and it was still prudent enough to raise capital and put even greater emphasis on liquidity, by revising upwards some of the key ratios. Every FD should follow Meddings’ example and look again to ensure that their balance sheet does not appear anorexic.

On my desk is an RBS paper dated June 2006 entitled Leverage ­ why you can’t beat them, why you should join them. Unlike any piece of paper more than about a week old, it has remained on my (obviously) immaculately tidy desk because it is a leitmotif of the prevailing culture of the time.

Part of the conclusion says: “We believe that corporates should review whether their debt/equity level is optimal and also whether their debt composition is optimal.

“Corporates that continue to run inefficient capital structures will be at an increased threat of shareholder activism and a takeover bid.”

The message of the time was clear: gear up, before someone else does it for you. And the subtext was that there were plenty of banks willing to lend the cash to whoever wants to do the deal. In the same month the RBS paper was published, airports operator BAA agreed to be acquired by Spain’s Ferrovial in a deal worth £10bn ­ a deal that some observers later suggested was a bad buy because Ferrovial had debts of £17bn from the acquisition.

While hindsight places previous actions under a harsh spotlight it doesn’t necessarily help work out how FDs should be structuring their balance sheets today.

However one point is clear: in hard times cashflow is under pressure. If the free operating cashflow can’t be guaranteed to meet key financial obligations, such as debt and dividend payments, the balance sheet has to be robust enough to take the strain.

For FDs in any business, this stress testing includes checking for major risks on and off the balance sheet that might hit cash. Equally important is remaining on top of the amount of cash within the group.

Longer term it is important to ensure that future financing is in place. If debts are maturing, will the banks renew?

The answer at the moment is often no. The FD may have to become familiar in previously untapped sources of finance, such as bonds and private placements. Corporates need to work hard to ensure they don’t give lenders any excuse to walk away or put the price of lending up. So businesses must avoid breaching financial covenants and downgrades by credit rating agencies.

Good FDs give themselves and their companies options in order to survive, and that means strengthening the balance sheet. Financing and refinancing opportunities should be grabbed.

If that means presiding over what was once seen as an inefficient corporate structure, then so be it: you can rest assured that no one will dare complain.