The term “fortress balance sheet” was propounded by Jamie Dimon, the CEO of JPMorgan & Co to mean having a balance sheet that has the ability to withstand shocks, particularly factors like contingent liabilities and covenant breaches. The best way to pass safely through a storm is by often being prepared before it hits, in the case of small businesses, it implies building a fortress balance sheet. In this article, we see what a fortress balance sheet means, its history, and how to build it.
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What is a fortress balance sheet?
A fortress balance sheet refers to a balance sheet that has the ability to withstand financial shocks while giving companies flexibility in deal-making. This points out that companies that do the best deal do them at the trough of a business cycle, not at the peak. In essence, the term implies a company taking steps to make its balance sheet shockproof by building liquidity.
Here, it is important to note that a fortress balance sheet is not a type of balance sheet, it simply refers to a company taking steps to make its balance sheet shockproof by building liquidity. Making an illustration with a frontier outpost or an ancient walled city, businesses that are prepared for a siege or unfavorable events such as recession, natural disasters, pandemics, or adverse regulatory change, can always survive in difficult circumstances until the crisis passes away or when rescue arrives.
Jamie Dimon, the CEO of JPMorgan & Co, who came up with the term describes it as a balance sheet that is unquestionably strong with suitable reserves and strong credit ratings. With this just as stated previously, a fortress balance sheet allows a company to withstand difficult events while maintaining flexibility to still deploy capital as it sees fit. So in events of severe shocks especially those that come with little or no warning like contingent liabilities and breaches of covenants, a company should develop the capacity to withstand such, while maintaining the ability to make deals. Emphasizing the importance of maintaining good credit ratings. Here, during good times, rating determines what one pays for his capital, and in bad times, they determine one’s access to capital.
The fortress balance sheet explained
A fortress balance sheet also implies that debt as a percent of equity should be as low as possible. In summing up debt, equity, and retained earnings, if the debt is less than 50% of the summation of the three components, then a firm is on its way to building a stronger foundation for its balance sheet.
One of the greatest pandemics was experienced in the year 2020 which brought economic consequences to small businesses. This situation serves as a very good example of a storm that a business should account for which can be done by building a fortress balance sheet. However, building this strong balance sheet is not just a good idea for mitigating risk.
Healthy cash reserves, as emphasized, can also enable a firm to capitalize on opportunities, expand locations, or introduce new products. It is also important to monitor counterparty risk and the greatest of this is said to be the cash invested around the globe. With this, not only balance sheets and credit ratings should be monitored but subjective matters as well such as bank strategy and the quality of the banking relationship. Stocks of companies with fortress balance sheets include Coca-Cola (KO), Honeywell (HON), and Public Service Enterprise Group (PEG).
A brief history of fortress balance sheet
Jamie Dimon who was the CEO of JPMorgan Chase oftentimes credits the success of a company through good and bad markets to always maintaining a fortress balance sheet, which he propounded. Back before the Global Financial Crisis of 2007-2008, Dimon had a relentless focus on having a firm’s balance sheet prepared to be able to withstand all the phases of the business cycle despite being criticized for being too conservative or risk-averse. This, however, left the firm in a stronger position than many banks that needed bailouts or became insolvent when the crisis did strike.
Trying to understand the financial statements of a big Wall Street Bank is a herculean task but the concepts involved in Dimon’s fortress balance sheet approach are straightforward. To many, the approach is applicable to individuals as much as it is to one of the largest financial institutions in the world. The main components are ensuring sufficient liquidity at all times and not being highly leveraged. With this, one will be able to withstand unexpected shocks while maintaining flexibility if opportunities arise.
Working with an advisor to have a better understanding of the balance sheet will also prompt one to organize his finances. Here, a better relationship will exist where both the advisor and the advisee can better the latter’s personal habits around money while building his own version of a fortress balance sheet.
How to build a fortress balance sheet
- Control inventory and receivables
- Keep a tight rein on debt
- Monitor credit
- Reconcile balance sheet accounts quarterly
- Get rid of non-performing assets
- Calculate ratios
Control inventory and receivables
These are asset accounts that directly affect cash reserves. For instance, carrying excess inventories can bring about depletion in cash because the company must continue insuring, storing, and managing items that are not generating profit. Also, looking at customer payment trends, clients who are behind on payments can squeeze a firm’s cash flow quickly, especially in cases whereby they purchase significant levels of goods and services and fail to pay thereafter.
Keep a tight rein on debt
Generally, a company is to make use of debt financing for capital items such as plant and equipment, computers, and fixtures (fixed assets) that will be used for many years. By financing these items with debt especially when interest rates are low, a firm can direct more cash toward day-to-day operations and new opportunities.
Two rules for debt are to avoid borrowing more than 75% of an asset’s worth and to aim for loan terms that do not exceed the underlying asset’s useful life. It is on this account that it was stated above that a fortress balance sheet means that debt as a percentage of equity should be as low as possible. The summation of debt, equity, and retained earnings, if the debt is less than 50%, then a firm is actually building a stronger foundation for its balance sheet.
A strong relationship between a business owner and his banker can be helpful in keeping the business afloat. It is important for a business to monitor its credit rating on a regular basis and investigate all questionable transactions that appear on its credit report. As it is with personal credit, a business credit score will go up as a firm meets up to its financial obligations promptly.
Reconcile balance sheet accounts quarterly
It is critical for a business to reconcile its asset and liability accounts at least on a quarterly basis. A well-supported balance sheet is capable of guiding decisions with regard to cash reserves, debt financing, inventory management, receivables, payables, and property. Regular monitoring will help highlight vulnerabilities in a firm’s fortress thereby providing time for corrective action.
Get rid of non-performing assets
It is possible that a firm owns a store across town that is losing money or has a warehouse that contains a lot of obsolete inventory. It is good to consider getting rid of these and other useless assets in exchange for cash.
It is important for a firm to know how its bank calculates the lending strength of a business, and then calculate them for its business. For instance, banks are interested in knowing a business’s debt service coverage. Having enough cash to handle principal and interest payments is crucial. Here, one is meant to work on his cash flow to provide enough room to service this debt and any future debt. Other ratios are not to be neglected as they are key and should be improved over time.