A Recession Ready Balance Sheet

With so much talk of a recession on the horizon, it’s enough to make a business owner paralyzed with indecision, worry and perhaps a little fear. Is my company ready? Will my company survive? What shall I do to prepare? These are likely questions running through your head.

The answer may not be as complicated as you think.

Let’s dive in…

When we think about a recession we think about our ability to withstand adversity and our ability to pay our bills. Those may seem like abstract concepts but they are actually measured by 2 ratios on your balance sheet:

Current Ratio - aka “liquidity”, aka your ability to pay your bills

Debt-to-Equity Ratio - aka “safety” aka, your ability to withstand adversity

Let’s say you anticipate a recession on the horizon and want to be prepared for this possibility. 

Your objectives should be to increase liquidity and safety.

Focus first on liquidity, defined as your ability to pay bills, is measured by dividing your current assets by your current liabilities.  “Current assets” are cash and other assets expected to be converted to cash within twelve months. “Current liabilities” are amounts due to creditors within twelve months. This relationship is called the “current ratio.”

A current ratio of 1.50 to 2.00 is usually considered adequate. This means you have $1.50 to $2.00 in current assets to pay every $1.00 of current liabilities. The higher the ratio, the more liquid and the easier it is for you to pay your bills. If paying your bills in a recession is likely more challenging, increasing your current ratio above this range would be a defensive tactic to feel more comfortable. 

What is that higher range? It is likely different for each business, but use your instincts, your industry’s economic factors, and trusted advisors (banker, CPA, CFO, management team, advisory board) to help plan for the optimal level of liquidity.

Now let’s consider safety. Safety is defined as your ability to withstand adversity. It is measured by dividing all debt by total equity. A low debt-to-equity ratio is safer than a high one (think lower golf scores). Typically a debt-to-equity ratio of 1.00 is considered a reasonable level for safety. It means that for every $1.00 in debt, you have matched it with $1.00 in equity. 

Put another way, you have the same amount of “skin in the game” as your creditors. However, when creditors see the debt-to-equity ratio increase, they get nervous and may cut off your access to debt, leaving you with a gap in your financing requirements. 

Conversely, lowering your debt-to-equity ratio below 1.00 in anticipation of a recession helps ensure you are in a good position to have the financing you depend on available. For example, lowering your debt-to-equity ratio by paying down your line of credit before a potential downturn would be an excellent Plan B to ensure you will have access to borrowing when needed. 

Now is an excellent time to start if you aren’t currently tracking these two ratios. Download Business Mastery, which will calculate these (and other ratios)  annually and monthly. 

Spend 60 minutes each month reviewing your ratios, and you will ensure you are well-prepared for potential stormy seas ahead!