Business Constraints are Always and Everywhere a Balance Sheet Phenomenon
Liabilities can constrain businesses
The Nobel Prize-winning economist Milton Friedman (to whom I am not related), has been quoted as saying that “inflation is always and everywhere a monetary phenomenon.” I’ve come to adapt that saying for finance: business constraints are always and everywhere a balance sheet phenomenon. What I mean by this is that a company’s balance sheet explains its constraints.
A heavily indebted company whose assets are not growing quickly will find itself in a cash crunch. Before we explore this further, let’s quickly review what the balance sheet is, and what information it contains.
The balance sheet reports a company’s assets, liabilities and shareholders’ equity. The balance sheet is where the fundamental accounting equation, Assets = Liabilities + Equity, comes into play. The equation must balance; hence, the financial statement’s name.
It is often easy for people new to finance and accounting to think of the balance sheet in terms of their own personal finances: Assets = Liabilities + Net Worth. If I have $100,000 in the bank and $10,000 in credit card debt, my net worth is $90,000: $100,000 = $10,000 + $90,000. Similarly, a business that has $100 million in the bank and $10 million in liabilities would have shareholders’ equity of $90 million: $100 million = $10 million + $90 million.
Looking at bankrupt company’s balance sheets is instructive. J. C. Penney’s balance sheets are available here. I rebuilt their balance sheet in Excel, and have screencapped some of the important details:
From May of 2019 to May of 2020, J.C. Penney’s Shareholders’ equity, essentially the net worth of the company, declined from just over $1 billion to $348 million (recall that the numbers shown above are in millions of dollars; i.e., 100 = 100 million).
Current liabilities are generally those debts due to be paid by the company within one year, and they are typically financed by their counterpart, current assets. The ratio of current assets to current liabilities, conveniently called the current ratio, is a measure of liquidity, and financially healthy companies have current ratios greater than 1.0. That is, financially healthy companies have more than $1 in current assets for every $1 in current liabilities: they can easily pay their debts with their assets. Not so for J.C. Penney: its current liabilities are almost twice as large as its current assets: its current assets can only pay for about $0.50 of every $1 in current liabilities!
As you might surmise, this limits J.C. Penney’s options: it constrains the business. Thus, business constraints are always and everywhere a balance sheet phenomenon. To easily answer the question, “Why did J.C. Penney declare bankruptcy?” we need only look at its balance sheet, and see that it can’t pay its debts. Because it can’t pay its debts, it can’t invest in new employees, new product lines, technology to improve its operations, etc. Its constraints are significant, and they are an albatross around its corporate neck.