Agency financial health-balance sheet considerations

Rough Notes, Jul 2002 by Di Stefano, Paul J

Financial controls must be in place before acquisitions can be considered

As chairman of ITT in the 1970s, Harold Geneen built that organization through numerous acquisitions. When asked for the secret of his business success he replied: "Don't run out of cash." Although this seems like a fairly simplistic comment, I think it is worth remembering.

Many of our clients have expressed a desire to acquire other agencies in the belief that their organizations are ready to absorb and profit from such an exercise. However, after a little digging it becomes readily apparent that many of them are not ready to handle a major acquisition-at least not until they put their own financial house in order.

Perhaps walking you through a representative example of an agency that was able to accomplish a financial restructuring and ultimately completed a significant acquisition would be helpful.

We began our affiliation with this particular property and casualty agency several years ago. The agency partners had a goal of doubling their size from $2 million in revenue to $4 million in revenue by acquiring a local competitor with whom they had maintained a relationship for a number of years. The primary challenge was that the partners were having difficulty putting together a coherent business plan, which would be critical to raising the necessary cash for the acquisition. The lack of proper financial controls over their existing operations made presenting a viable story in the plan even more difficult.

The agency partners recognized that they lacked the skill sets necessary to make their goals a reality, and we were engaged to assist them.

During our initial analysis of their financial statements, we discovered that the agency's operating margins were significantly below acceptable standards and the agency's balance sheet was, to be kind, problematic. Our financial consultants decided to begin the engagement by focusing on the agency's balance sheet. The rationale for this approach was the fact that strong positive cash flow would be a priority in successfully completing an aggressive leveraged acquisition. Appropriate financial controls over receivables and payables would be a must going forward to avoid any unpleasant surprises.

Accounts receivable issues. A significant portion of receivables was past due, with some being more than a year old.

Causes: Lack of accoutability for collections and company audits performed long after policy expiration, resulting in client not being billed.

Recommendations:

Collection related:

* Existing clients were contacted to work out a strictly monitored payment plan.

* A local attorney was hired to collect the balances on a contingent basis.

* The remaining bad debts were written off, gaining state and federal tax benefits.

Operational related:

* All company audits time stamped and billed within 24 hours of receipt, if not collected within 30 days returned to the company for direct collection.

* Wherever possible, accounts were transferred to a direct bill basis.

* An automated process was installed to produce letters and statements to the clients as a reminder.

* Policies were canceled as soon as they past 30 days.

* Producers were held accountable for all past-due balances.

* Producers were charged with percentage of uncollectible balances.

Company payables issues Insurance company payables were never reconciled to the general ledger. Harbor Capital Advisors' analysis determined that the company payables were materially understated.

Causes:

* Incorrect commission rates were entered in the agency management system as a result of the lack of communication between producers and accounting regarding special commission rate deals made with companies.

* A general acceptance on the part of agency management that whatever was billed by the company was correct.

* Bills were routinely being coded to the wrong company resulting in individual company payables being either understated or overstated.

Recommendations:

* The discrepancy uncovered in company payables was written off, thereby resulting in a tax benefit.

* Company statements should be reconciled to agency's billing records.

* Standard commission rates by line of business and company should be set up in the computer system with only authorized changes permitted.

In summary, the balance sheet is an important management tool that is very often neglected as a management tool by agency principals. The agency income statement is only half the equation; if the key accounts on the balance sheet are not reconciled, it is highly likely that the agency income statement is also misstated. Unfortunately, agency balance sheets are routinely ignored until such time as the agency's financials are required for due diligence in a sale or securing a line of credit. Dealing with the reconciliation process at those critical times can be an unpleasant experience to say the least. This is clearly a case where an ounce of prevention is certainly warranted.

The author

Paul J Di Stefano, CPA, CPCU, is the managing director of Harbor Capital Advisors, Inc., a national financial and management consulting firm which offers services to the insurance industry. Services include agency appraisals, merger & acquisition representation, strategic and management consulting. Harbor Capital Advisors, Inc., can be reached in New York at (800) 858-2732 or visit its Web site (www.harborcapitaladvisors.com).