If you’re profitable on paper but can’t tell how fast you can afford to grow, this episode will hit home.
In this episode of The Free to Grow CFO Podcast, Jon Blair sits down with Kevin Jornlin, one of Free to Grow’s CFOs, to give founders a practical guide to balance sheet health. They break down why the balance sheet matters whether or not you’re capital constrained today, how the cash conversion cycle determines how much of your profit actually shows up as cash, and why a big gap between your current ratio and quick ratio often points to excess inventory. They also tackle how much debt is too much, including a $14M brand that took on a $5M loan and survived because the founder had left $5M of equity in the business.
This episode gives you the balance sheet metrics to watch so more of your profit becomes cash you can reinvest or pay yourself.
Episode Links
Jon Blair - https://www.linkedin.com/in/jonathon-albert-blair/
Kevin Jornlin - https://www.linkedin.com/in/kevin-jornlin-cfa-650a40b/
Free to Grow CFO - https://freetogrowcfo.com/
Key Takeaways
Your P&L tells you whether you’re profitable, but your balance sheet tells you whether that profit is actually available as cash.
Size debt from both the income side and the equity side, because too much leverage turns a growth bet into a binary outcome.
A current ratio below one isn’t automatically a red flag if you hold strong cash and your liabilities aren’t due for months
Transcript
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00:39 The Importance of the Balance Sheet
05:52 Understanding the Cash Conversion Cycle
11:13 Current and Quick Ratios Explained
16:43 The Role of Debt in Balance Sheet Management
26:52 Unlocking Growth Through Balance Sheet Efficiency
Jon Blair (00:39)
All right, we are back and I've got my buddy Kevin Jornlin, one of our CFOs. I think is this a three Pete?
Kevin (00:48)
Third time. I got two more until I get to the five timers club.
Jon Blair (00:51)
I love it, man. last time you came on, we had a really fun conversation. We talked about, I would say maybe the sexier side of our job, which is like helping scale a brand 10X in 12 months. Today we're gonna talk about maybe the unsexier side. It's really important to us as CFOs. The PL is the financial statement in e com that gets all the love from founders. And there's this.
Other financial statement that we care a lot about and is arguably even more important in many instances to the brands that we work with. But it gets no love. And that's the balance sheet. And so today we're gonna talk about balance sheet health. We're gonna talk about the founder's version, what you need to know as a founder, the the importance, the key factors that you need to understand at a high level. Because why? I think in its simplest form.
Cause you can generate all the profit in the world on your PL, but it does not mean it turns into cash unless you know how to manage your balance sheet. So, Kevin, before we get into some of the key metrics that we're looking at as CFOs at Free to Grow, just what is your personal viewpoint on where the balance sheet fits into the the holistic kind of a financial assessment of a D to C brand?
Kevin (02:13)
All right. I will try to make this as sexy as possible. it's a tall order. so so balance sheet. First, first, what is the balance sheet? Just at a very basic level, it's a snapshot at a point in time of all the stuff you own, all the stuff that you owe, and then what's left over, which is your equity.
Jon Blair (02:17)
Ha ha ha.
Kevin (02:34)
Okay, so that's a very basic level. So why did so your question is why is it important? Okay. Let me say at a very basic level, th the hold on, let me back up. Okay. okay. All right. Okay, so why is it important? All right, so so that question depends on
Jon Blair (02:48)
Yeah.
Kevin (02:58)
Whether or not you are capital constrained as a business. Okay, so I would break it into two different camps. Let's say business that is capital constrained versus business is not capital constrained. If you're capital constrained, what does that mean? That means that you are you're inhibited, your growth is inhibited by the lack of available capital. In other words, you want to go out and buy more inventory, but you just don't have the money to do that. Okay.
So that's a big that's a big issue that you need to solve, and we we solve that through the balance sheet or or through some other tactics that we can talk about in a second. in scenario two, let's say business is not capital constrained. In other words, you're able you would like to grow, and maybe you're not growing as fast as you want to, but the thing that's holding you back isn't capital. In other words, you might
Like plenty of capital, you're just not able to sell enough stuff. All right, in that case, maybe this balance sheet management conversation is a little less relevant, but I'd argue still very relevant for you because then you you you can start to get into questions about things like how much should I pay myself? Right? So let's say you've got a lot of liquidity, should you take a dividend out? that's the type of thing that getting your
balance sheet right is very important to understand. Okay?
Jon Blair (04:33)
The the capital constraint perspective is interesting. I was not thinking about that going into this conversation, but I I think I think I wanna elaborate on your second point about or like the second scenario of being not capital constrained. I wanna just give an example that came to mind as you were talking. Like, let's just say that you're doing a couple million in revenue and you have plenty of inventory and cash to sustain your current PL operations, right? But what happens if you unlock a marketing constraint?
And you double the business. Do you then become capital constrained? Do you have enough capital at that point to keep up inventory or cash flow wise? And so adding on to your kind of caveat of like, I would argue the balance sheet still matters because you could become capital constrained, right? Under future conditions. And so it's important because how fast your business can grow cannot only be answered by the PL.
It has to be answered by the balance sheet as well. And I would argue probably even more so on the balance sheet in terms of like, do you have enough resources available? Another way to think about the balance sheet, because a lot of the most common questions that come up to me or like from brands are one, am I holding too much or too little inventory? Two, how much debt is healthy? Three, how much cash should I hold? Well, you can't answer those questions.
From purely the PL perspective. And I always tell brands like, look, the other trap if you don't look at your balance sheet is you may look at assets, namely cash and inventory, right? For for a D2C brand. You may look at cash and inventory, and without looking at the other parts of your balance sheet, your liabilities and equity, you might falsely assume that those balances are healthy when
not factoring in the fact that you owe other people money and you also have equity. So we're gonna dive into some of these metrics because I think we'll highlight some of these points. The first one that we that I probably talk about the most frequently is the cash conversion cycle. Kevin, do you wanna chat through the cash conversion cycle a little bit? What is it? Why is it so important to understand as a D to C founder?
Kevin (06:49)
Mm-hmm.
Yeah, for sure. Okay, so there's a technical definition behind it that maybe I'll I'll give in a second, but first the s so this business, e-commerce business, in general is about buying inventory, waiting a period, and then selling that inventory and turning it into revenue, turning it into cash, right? So the
In generally speaking, that the days that you wait holding that inventory is one component of it. The days that you wait is your cash conversion cycle. So it's expressed in the number of days. Okay. so so the big one there that I mentioned is inventory. The longer you hold inventory, that's bad. That increases your cash conversion cycle, increases the number of days. the
Longer, let's say you have bad payment terms where you have to pay your supplier up front and then it gets put on a boat, and then you wait, and so that that's bad. That increases your cash conversion cycle. And there are a few other components to it as well. But the question is basically like, why is this? Why should I care about this? Right, if my cash conversion cycle is 50 days versus
Versus 100 days. Like it's kind of tough sometimes for brand founders to conceptualize what that means because it's a little bit abstract. And I almost like liken it to so I come from an investment background. The magic of compounding and compound interest is another sort of an abstract concept where the difference between, like as an example, the difference between getting a 7%
Kevin (08:44)
Return on your money and an 8% return on your money. Well, that's only 1%. Like to the common person, that might not sound like that much. Over a certain period of time, and I just I just looked this up on my own. After 70 years, the difference between those two returns is double. So, in other words, you will have double the amount of money after 70 years with an 8% return versus the person who got a 7% return, and it's like it's
Crazy the when it goes to like seven percent versus nine percent return. Well, then that doubling time shrinks down to 30 something years, and so the the reason I bring that up is it's almost difficult for the human brain to wrap their mind around how that could be possible, like eight percent versus seven percent. How could I be? That's just a little bit more. How could I be left with double? This similar.
Logic goes into this cash conversion cycle concept. The difference between a hundred days and 50 days is massive. And it's not a perfect analogy, although the the the time value component is actually relevant here because the quicker you can get that cash back, the more it juices your return, the more you're able to invest it into inventory or do other product.
Jon Blair (09:55)
Yeah.
Kevin (10:14)
things with that money. So it's extremely important for you to shrink it as much as possible. Some brands maybe will even get it into a negative position. What is a negative position means? That means that that means that you are actually getting the cash from your revenue before you are paying your supplier for the inventory. So that's like nirvana, right? That's what
Jon Blair (10:44)
That's like Am Amazon. Amazon has a negative cash conversion cycle as a business. And and well, what's interesting, you know what I'm thinking about is the capital constraint thing you brought up at the beginning. Let's just use that ex let's say you have a 365 day cash conversion cycle, meaning your inventory purchases, that that those dollars go out the window and you don't get them back for a year. Think about the capital constraint to scaling in that situation.
Kevin (10:49)
Right. Maybe Costco, yeah.
Jon Blair (11:10)
Now let's reverse that and say you even have a negative one day cash conversion cycle. You get all your customers' cash one day before you pay the vendor. You're almost, this is not factoring in your liability. So it's not 100% true, but you're almost unconstrained capital wise at that point. If you can get the money one day before from your customers and then pay your vendors, you can place as big of orders as you want, right? As long as you keep to a negative one day cash conversion cycle. Now, the trick is what?
The trick is managing your cash conversion cycle. It fluctuates over time, as we see when we analyze it, usually fluctuates seasonally because if you have seasonal sales demand, you're having to purchase more during certain times of the year. But the concept from a founder standpoint is like one, how many days of inventory you hold matters to how much cash you have available to either take out and pay yourself or to plow back into the business to scale. And then the second thing is.
Your vendor payment terms matter a lot because the higher your vendor payment terms, the lower your cash conversion cycle. And usually when I see really solid cash conversion cycles like best in class, which by the way, generally speaking, I don't typically see e-com brands that have a cash conversion cycle less than 90 days. And when I see one that does, it's usually a combination of really efficient inventory days on hand and
fairly aggressive vendor payment terms. It's not one or the other. And so you really should be attacking both of those. And ultimately what the goal is, if you improve your cash conversion cycle, it's that you more dollars of more of every dollar of profit on the PL is available for is available in cash. The higher the cash conversion cycle, the less likely your profit dollars are even available to you in terms of cash flow. So I want to talk next about the current ratio.
What is the current ratio and and what is important about that from your perspective?
Kevin (13:11)
Okay, great. So so current ratio is your current assets divided by your current liabilities. There are certain
rules of thumb around this that maybe if you're like just starting out and at a basic level trying to understand the health of your balance sheet, it can be useful to look at. The more that you work with a CFO, the less we're gonna focus on that metric because they're kind of there there there are better ways of looking at things. But current assets divided by current liability. So current assets include your inventory and then also
Includes your cash, your accounts receivable. You divide that by your current liabilities. So that's like your credit cards and AP. And if you're focused on liquidity as the objective, you want like some safety, you want to make sure that your current assets are above your current liabilities, so you can have confidence that you can pay off all of your vendors, etc. So maybe a good rule of thumb on.
On that could be two. Two is kind of a number that you you hear as like a good target to have on that. But with a heavy asterisk, like this is what I say, like that's like step one. Once you get better, and and balance sheet management is like a never ending process of getting better, you actually may be better off reducing that over time and and doing so through.
Jon Blair (14:31)
Yeah.
Kevin (14:50)
Pushing out payment terms. So let me give you an example. So there are some brands that I work with that actually have current ratios below one. And that could sound really scary, right? What what does that mean? That means like the amount of cash you have on your balance sheet and your AR is not enough to cover the payments that you have due to your vendors within the next year. Okay. But what if
All of your assets are held in cash and those current liabilities aren't due for another six months. Well then you're actually in a really you're actually it if you got good visibility on this thing, you're actually in a good spot. and it's not a a a red flag, so to speak, actually could be an indicator that you're just very, very efficient in your balance sheet management.
Jon Blair (15:48)
It's interesting because I know you've heard me say this before on our CFO audits, but you can't take any one of these metrics that we've either covered or are going to cover and just say this by itself unequivocally tells me your balance sheet is in a good position or a bad position. It's literally it's much more like a dashboard in an airplane, right? Where it's like, I'll give you a perfect example. Let's talk about like elevation. If you're at a thousand feet.
in a a a Boeing 737. Is that bad? Well that depends. That depends on looking at your other instruments. If you're at a thousand feet but you are you are ascending because you're in the middle of takeoff, it's not an issue, right? If you see your elevation continuing to go up. If you're if you're in a free fall and you have you have some instruments telling you one of your engines are out and you're you're descending at like whatever 10,000 feet a second. I don't even know if that's a thing because I'm not a pilot
Kevin (16:23)
Mm-hmm.
Kevin (16:45)
Mm-hmm.
Jon Blair (16:46)
Then a thousand feet is really bad, right? It's the same thing with these metrics. Like, like I've actually I've actually told a number of brands, like, hey, your current ratio is low. But like your cash conversion cycle so solid, it kind of offsets that. And that's why we're still feeling cash flow move through the business. But then furthermore, you guys have very little debt and you've got seven figures of equity, retained earnings sitting on the balance sheet. So you have like a pretty good cushion to
effectively soften the blow of operations getting disrupted. And so there is no just single perspective. All of these tell you a different thing about the health of a portion of your balance sheet and what that might mean for liquidity risk, solvency risk. Solvency risk is your ability to meet your obligations. Liquidity is your ability to turn assets into cash, right? and and it and you
That this is why a CFO is so important. Like not I not to toot our own horn. I don't like to talk a lot about like why free to grow is so great on our podcast. but just generally the reason you need a CFO is because even like if you go try to use AI for like assessing some of these metrics, it'll give you benchmarks, but it can't help you judgmentally look at three, four, five of them, right? Back against the risk tolerance of the founders and
what's happening on the PL and the business plan and help you determine if you're good to keep allocating resources in a in a certain way towards a certain trajectory. There is a lot of finesse in this and it changes. You can make a decision for a period of time that you reverse or stop at some point later. So anyways, don't need to go on a rant further about that. But I want to talk next about the the close cousin of the current ratio, the quick ratio. What is it?
And what's the difference between the quick ratio and the current ratio?
Kevin (18:46)
Okay, so current ratio I said was current assets divided by current liabilities. Quit ratio is very similar.
Except the current assets part of it excludes inventory. Okay, because inventory usually not it it not that easy to quickly turn to cash. so if we really want to look at a more conservative metric, it's just the current assets X inventory, so that's just really cash and AR divided by current liabilities.
Jon Blair (19:16)
Yeah, and what one thing I like to do with this metric is just look at the difference, the variance between the the current ratio and the quick ratio. Usually when I see a brand that has a high cash conversion cycle, I go and I say, well, that's because you have really high inventory days. And then I see a pretty big spread between the current ratio and the quick ratio. And because the only difference between those two ratios is inventory is in current and not in quick, I can say, Hey, I I have a second indicator telling me that I think you guys are long.
On your inventory position. You guys are heavy, right? And then I can also then go look at some other metrics and look at cash flow, the cash flow statement, and say, like, hey, inventory I can see visibly in three or four different places is weighing down the cash flow of the business. That tells me we should maybe scrutinize a little bit more. Why did we get into this inventory position? Should we sustain it? Should we correct it? Right. because I'm seeing it show up in more than one place.
Kevin (20:10)
Yeah.
Kevin (20:16)
Yeah, and and let me add that I mean the through line to much of this conversation today is around inventory. That is often the cause of problems when it comes to balance sheet management and balance sheet health.
There are easy problems to solve when it comes to being overstocked on inventory, and then there are hard problems to solve. And the low-hanging fruit for a lot of the like clients we start working with is really just over-ordering inventory. And in many in many brands, it's it's just as simple as ordering less or ordering on a more consistent cadence. If you really dig into it with the founder on like, hey, why are you ordering every two or three months?
These big chunks, and then that inventory is sitting on your balance sheet for a hundred days or more. Maybe they don't have a good answer for it, and we can get them a more a better process for doing that consistently and then optimizing it between some other lower level. so we can do that. That I put that into the category of easy problems to solve.
There are some very difficult problems to solve when it comes to, let's say, clothing brands that have a lot of old styles or seasonal styles that just aren't selling. So it's not really a question of like their inventory ordering cadence. It's about the stuff they already have from years and years ago that they just can't get rid of. And this is where it's like no no easy solution. I mean, you can consider liquidating, like liquid.
using a liquidator, you can consider discounting heavily. you could even consider donating that product if there's like a tax benefit for doing so. So those are conversations we do have with our our brands that that are in that type of a position. But yeah I I do I would say it's some of those problems are are not easy to solve.
Jon Blair (22:23)
Yeah, so let's talk about the last area that I want to hone in on, which is debt. Because the the compounding w where where I have oftentimes seen the worst or the hardest financial challenges occur as it relates to inventory is when there's this intertwined improper use of debt that was used to finance said inventory. So now you have this asset that is.
got liquidity problems because we've bought too much or we bought the wrong stuff or we bought at the wrong time of year. It's finance with debt, which has to be serviced. It has to be paid back. Interest and principal has to be paid back. And so you've got kind of this liquidity conundrum on your hands where someone's saying, I need to get a payment or else I can enforce rights against your business. And you're saying I might not have the payment
Because all of your cash is stuck on the shelves at my 3PL or in my warehouse. So, Kevin, when you're helping brands think through the the question that we get all the time, can I take on debt? How much can I take on? Like what's too much, what's what's too little? What's healthy? What are some of the perspectives you think about with assessing the health or lack thereof of the debt that you see on the balance sheet?
Kevin (23:45)
Well, let's first recognize that debt can be helpful in optimizing that first metric that we talked about, which is cash conversion cycle. Right? So if you have a very, let's say a predictable business that's selling let's let's say it's a high LTV business that's selling like a supplement or something like that, and it's just growing steadily.
And you're just focused on optimizing for cash conversion cycle. Well, a great way to do that is to get to get a short term debt facility, like we often and we often recommend that. this effectively pushes off your payment terms and juices that cash conversion cycle metric and therefore juices the return on invested capital and business, et cetera. but as you yeah, as you mentioned, this is not appropriate.
appropriate for everyone. So it depends very much on well the type of business that you have. So the that predictable ig business example I gave is one, but if we go back to the clothing example that maybe has a highly seasonal business with a lot of uncertainty, I would argue debt facility might be less less appropriate for for that brand. Of course all you know any
Anything could be appropriate in depending on the size that we're talking about. and so when it comes to size, you start looking at certain metrics like debt service coverage would be one. So you you want to make sure that you have enough operating income, and that operating income is consistent enough that it well exceeds the interest expense on that debt. Okay, and then they're just there's just
Many different kinds of loans. We don't need to go into all the different variations on this call, but some loans are better than others, right? And some have maybe like an enticing element of them that's like you know, a credit card that has like 30% interest rate. You don't you don't think you don't realize it's got that 30% interest rate, you just see minimum balance. Like there are there are debt solutions like that that we would just want to heavily avoid.
Jon Blair (26:05)
Yeah.
Kevin (26:11)
And then there are others that can be very appropriate, depending on the brand.
Jon Blair (26:15)
Yeah, the the example I always like to use is that when when it's like, hey, how much debt? I actually one of our CFOs on Friday called me and was like, hey, this brand is at this much debt. They want to get up to this. This is what I I'm starting to feel uncomfortable. I I think that where we're at is appropriate. But like, how should I be thinking about this? And we were just kind of chatting through some different dynamics. And I was like, hey, let's all remember here.
You know, it's it's actually no more complicated than going back and looking at a mortgage, which a lot of people have gone and applied for. A lot of people, you know, a lot of people at our age have one. and what those mortgage lenders are looking at two perspectives, and so are all the lenders that are lending to e com brands. There's the the PL perspective, that's the debt service coverage ratio, the inverse is debt to income.
Or it's like yeah, you can look at it from the other perspective, but it's just what is your income relative to the debt payments? And there's different ways to measure it. Mortgage lenders use DTI, and and generally they want to see you making at least two times all of your debt payments combined, right? I would argue that that's risky for me personally, but there are some people who are happy to do that, right?
so that's the income perspective, r relating your your business's income to the debt service and making sure you make more than what is needed to to pay the loan and service the loan. The second is the balance sheet perspective, and that's how much debt do you have relative to your equity? I always use this example. There's a client that I had in the early days of Free to Grow. They were only doing 14 million in revenue and they wanted to take a five million dollar loan.
That's feels like a lot, right? They wanted to buy five million dollars worth of inventory. They're only doing 14 million in revenue. It was a big swing. You know why I told them I I I warned them of the risk, and they ultimately bought way too much inventory. But you know why they survived and why I felt okay saying, hey, listen, I think this is risky, but I think we can survive. It's gonna take a lot of work, but here's why. Because that founder had left five million dollars of equity on the balance sheet.
Jon Blair (28:24)
previous retained earnings that he did not distribute to himself. So basically that five million in debt was 50% leverage. 50% $5 million in debt and $5 million in equity, right? Ten on a $10 million capital structure. If it that was an I've had other brands come to me and say, I want to take on five million dollars worth of debt. And that was 80% of their capital structure. That would be for me like a straight up
No, dude, please don't do this unless you have cash sitting somewhere outside of the business that you can bring in as equity if this bet doesn't pan out. And so you need to look at both of those perspectives. And ultimately, what this comes down to is risk, right? Like you can afford a a a lower debt service coverage ratio if you're willing to take more risk. You can have a higher debt to assets ratio if you're willing to take more risk. But just know that as those metrics go in certain directions, it does become more risky and you are betting.
More and more, you're getting closer to a binary outcome. This is either gonna work and I'm gonna make a lot of money, or it's not gonna work and I'm gonna shut my business down. And so we as CFOs wanna make sure you're not making placing a bet with a binary outcome by using an improper amount of debt. So anyways, Kevin, we talked about some good stuff here. Cash conversion cycle, current ratio, quick ratio, some of the debt metrics. What is what's kind of the final big idea that you wanna leave our audience with?
as the final takeaway for like how a founder should be thinking about their balance sheet.
Kevin (29:54)
Yeah, the be so let's bring it back to the benefits, right? As I as I said at the top, like the the the goal with making the balance sheet more
efficient is that it unlocks possibilities and possibility number one with a more efficient balance sheet is what founders often care most about which is how much can you pay yourself right that is that is and I I should I should mention you know the
going back to the capital constrained business versus not capital constrained business, like if you can reinvest in inventory, the inventory of these businesses generate very good returns, typically speaking. So like
You can when you have more cash freed up on the balance sheet, like that's typically what you want to do first because you get the highest return on that inventory. But again, let's say that you don't need to buy more inventory because the growth is capped. The possibility number two is pay yourself, right? and then I would also encourage people that like once you've got the balance sheet in a really nice spot to use that.
That extra cash to do things that might in the future drive growth. Things like new product development, right? Or things like placing small risk adjusted bets on new markets or new products, such that you can drive growth in the future. So this is a conversation about balance sheet, but very much ties back to like unlocking the growth potential in the business. Once you've got your balance sheet
Kevin (31:43)
It up, you can consider those other types of things. I guess the final thing I I would leave you with is
I think I mentioned this is a never-ending process. We've covered today some of the low-hanging fruit related to things like having too much inventory or things like the utilization of debt. But you can n I mean you can always go a level deeper when it comes to this topic of of of optimizing for payment terms, optimizing for your SKUs. I mean we we we can cover
This is on our next call, perhaps. But if you've got different yeah, if you've got different SKUs that have different payback periods or different days inventory, outstanding, like it can be very challenging for brand founders to understand where we should be focusing one versus the other. All of those things can be very helpful in service of ultimately.
Jon Blair (32:24)
Episode four.
Kevin (32:51)
Like just getting things more and more efficient and and juicing that internal rate of return in your business.
Jon Blair (32:57)
I love it, man. Well, this is a great conversation. My final thought is like, look, P L is important, but in the game of scaling a business, you need to get better and better at allocating resources. And the balance sheet is the snapshot of your available resources, net of the resources that you owe to other people. And so you cannot allocate resources without having that snapshot. Kevin, thank you for coming on.
I already feel the seating for the four peat coming here. It's a balance sheet part two. But thanks for dropping some some knowledge on this topic. I know that everyone's gonna find it super helpful and I appreciate you joining the show, man.
Kevin (33:40)
Great to be here. Thanks, Jon.
