Focused On Your P&L? Check Your Balance Sheet Instead

A few days ago the juxtaposition of two articles, one in The Wall Street Journal and the other in The Times (UK), struck me as too rich not to point out.

The WSJ wrote, in "Gap Widens Between Tech Richest and the Rest," that:

A handful of cash-rich companies are consolidating power in the technology industry, using their wealth to expand into new businesses and making it harder for small and midsize competitors to break through.

In the past two years--in the teeth of the recession (think about it)--Apple, Google, Microsoft, Oracle, and six other large tech companies generated over $68-billion in new cash, compared with $13.5-billion, just 20% as much, for all of the other 65 tech companies in the S&P 500 combined.  The results are clear:

Because of their massive cash accumulation, these companies can afford to take risks that smaller companies can't at a time when the economy remains fragile. The result is a bifurcated tech landscape, says Erik Brynjolfsson, a professor at the Massachusetts Institute of Technology's Sloan School of Management. [...]

The repercussions from the cash discrepancy are being felt throughout the industry. Some midsize tech companies are giving up trying to compete with their larger rivals.

"I'm not going to fight" being a mid-tier company, says Enrique Salem, chief executive of security-software maker Symantec Corp., which has annual revenue of $6.1 billion and cash reserves of $2.6 billion. "It's a losing proposition for me to try to catch up with Oracle."

So what's a smaller or mid-size competitor to do?  Assuming that folding one's tent is not an option, the only answer is to take on more risk.  In plain English, you have to really stick your neck out:

Says Ciena CEO Gary Smith. "A large company can make a mistake in one of these acquisitions and it isn't going to be hugely impactful to them."

Ciena has no such luxury, he says. "Clearly, if we get this wrong, it will not have a good outcome."

Meanwhile, The Times (UK) wrote in "Law firms turn to banks, not partners, for cash," that:

Leading law firms increased borrowing by 40 per cent in response to the financial crisis, despite the sector's traditional aversion to taking on bank debt.

Debts among the 40 biggest legal practices whose accounts are publicly available rose to £591 million in 2008-09, according to data compiled by Grant Thornton, the accounting firm. The previous year the debts were £425 million.

Peter Gamson, head of the professional practices group at Grant Thornton, said that many firms had turned to their banks for funding rather than asking their partners to contribute more capital. The average partner now has £138,000 invested in his or her firm, compared with £128,000 before the crisis hit.

"It certainly looks like a lot of firms are going to a bank to get funding rather than sitting partners down and saying: 'Look, guys, we've got to put some more money in,' " Mr Gamson said.

Now, that may be lovely insofar as it helps partners sleep at night, but the clear message of our friend Mr. Gamson--as well, of course, as that of the entire tech industry as recounted in the WSJ--is that it leaves firms on very tenuous footing indeed.

The lack of working capital left many firms stretched when the downturn began, Mr Gamson said. "As a sector, [legal services] looks very undercapitalised. There's a huge reluctance to ask partners to contribute more capital. The question is how long you can play that game?"

Mr Gamson warned that the low ratio of capital to debt at many mid-tier firms could make it harder for them to grow when the market recovers. In addition it could deter funding from investors when new rules on outside ownership take effect next year. "Any investor is going to look at the business and think: 'Are the owners of this business being realistic about how much they're putting on the line?' " he said.

But we should not be surprised.  After all, the typical law firm (I'm hard-pressed to think of any exceptions, now that I think about it) "strip-mines" the firm of cash at the end of every year to pay partner compensation.  

Here's a parlor game for you next time you're feeling a bit churlish towards a colleague:  Challenge them to identify the balance sheet entry that appears on every corporation's statement but no law firm's.  The answer?  The line for "retained earnings."  I promise you no one guesses right.

Mr. Gamson puts it just about right:  "How long can you play that game?" 

And Ciena's Gary Smith completes the thought:  If you're playing with limited capital and make a mistake, "it will not have a good outcome."

You have been warned.2