Posts Tagged 'Liabilities'

January 9, 2008

More "GAHAP"

Our CEO said “so when will our next blog post on GAHAP come out?” By GAHAP he means “generally accepted hosting accounting principles.” He asked for it, so you get it :). If GAHAP bores you, try this on your iPhone. It’s fun!

I could probably squeeze everyone left reading at this point in a Dodge Viper and we could discuss this over lunch. But SL doesn’t provide Vipers to executives so I guess I’ll post it here for you. A balance sheet by definition is a snapshot of the current financial condition of a company. Here's a formal definition. A GAAP balance sheet simply doesn’t portray an accurate picture of the financial condition of a hosting company.

Probably the most important value that a GAAP balance sheet completely misses is the value produced by monthly recurring revenue. By implementing some sort of fair value accounting as I mentioned before this value gets captured. But on that part of the balance sheet, it still doesn’t help someone looking at the dreaded current ratio. So here’s a way to get a measure of this value that matches up to current liabilities on the balance sheet and get a current ratio that better reflects the company’s true financial position.

Since current liabilities include debt that must be paid at any time over the next 12 months, I would propose using statistics to walk forward 12 months and add “Future EBITDA from Existing Customers” as a current asset on the balance sheet. I can sense the shudders of all accountants who are reading this because you’re thinking that this completely abandons the revered principle of conservatism. In hosting, however, this can be done with conservatism in mind by employing statistics. Public accounting auditors employ statistics every day in their work, so the use of statistics is not a foreign concept to accountants.

Here’s how I’d propose hosting companies do this. First, look at the behavior of the current customer base at the beginning of each month regarding customer churn and the purchase of incremental business by remaining customers. Ignore all new customers acquired during the month and add them to the customer base for next month’s analysis. For each month over the past 12 months, analyze how much revenue is lost from customers who leave and net that from how much revenue is recognized from the existing customers who remain. The results of this analysis can be statistically boiled down to give you an idea of how much revenue will come in over the next 12 months even if you do not gain a single new customer during the next 12 months. That’s the principle of conservatism coming into play here. Let’s call this “statistically stable anticipated revenue.” By the way, at SoftLayer, the incremental business from customers who stay is greater than the business lost from customers who leave us.

Second, take a look at EBITDA margins over the past 12 months and work the statistical mojo to get an idea of EBITDA margins going forward. Multiply this margin against the statistically stable anticipated revenue to arrive at “Future EBITDA from Existing Customers.”

Third, add this category as a new line in the Current Assets portion of the balance sheet as well as adding it as a new line in the Stockholder’s Equity portion of the balance sheet. The resulting balance sheet is much closer to the true financial condition of a hosting company than a traditional GAAP balance sheet.

Why is this view more accurate? 1) A hosting company isn’t like a retail store. Like a hosting company, retail stores have repeat customers but the repeat behavior is more sporadic. The customer may decide that the weather is too bad and they’ll run out and get that new pair of shoes another day. Or the weekend may have been too hectic for a grocery store run so they’ll eat out for the next week. With hosting customers, mission-critical things live on their servers and they are usually set up on automatic monthly billings. Repeat sales are much more predictable than for customers of retail stores. This consistent cash flow has real value, and to not capture it on the balance sheet negatively distorts the financial condition of the company. 2) Putting this statistically solid future EBITDA as a current asset allows a better picture of the current ratio because it is from this EBITDA that the current portion of the company’s debt will be paid. This gives a banker, etc., a clear view of whether the company will struggle over the next year to pay them back.

Here’s how a sample summary balance sheet would look before and after this adjustment.

                                                  <b>GAAP</b>            <b>"GAHAP"</b>
Cash, A/R, Other Current Assets                $33,218,805     $33,218,805
Future EBITDA from Existing Customers        <u>           $0     $26,575,044</u>
Total Current Assets                           $33,218,805     $59,793,849 
 
Fixed Assets                                   $90,355,150     $90,355,150
Other Assets                                    $9,301,265      $9,301,265
                                             =============================
<strong>Total Assets</strong>                                  $132,875,221    $159,450,265 
 
Current Liabilities                            $55,807,593     $55,807,593
<strong>Long Term Liabilities</strong>                          $67,766,363     $67,766,363 
 
Stock, Paid in Capital, Retained Earnings       $9,301,265      $9,301,265
Future EBITDA from Existing Customers        <u>           $0     $26,575,044</u>
<strong>Total Stockholder's Equity</strong>                      $9,301,265     $35,876,310
                                             =============================                                                                                   
<strong>Total Liabilities and Stockholder's Equity</strong>    $132,875,221    $159,450,265 
 
Current Ratio                                         0.60            1.07

-Gary

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September 18, 2007

Current Ratio Punishes Hosting

For the third (and final!) installment in this likely sleep-inducing trilogy of hosting and accounting blog posts, we'll cover Current Ratio and how it doesn't treat hosting companies fairly. Bear with me – this rant may run a bit longer than normal.

Current Ratio is easy to compute – simply go to the balance sheet and divide current assets by current liabilities and voila! You have the Current Ratio. OK, so what does it mean?

So why is this unfair to hosting companies? Well, where does most of the cash of a hosting company go? Into servers and networking gear! But guess what? These don't fall under current assets on the balance sheet and thus are excluded from the Current Ratio calculation. As a result, I'd wager that most if not all hosting companies have at some point been in the position of current liabilities being greater than current assets, where conventional wisdom says "the company may have problems meeting its short term obligations."

How does this hurt hosting companies? Suppose the company could use some short term financing for a network upgrade. If they go talk to a banker about this the banker might throw up his hands and say "I can't help you…you're in financial distress according to your Current Ratio."

I would argue with the banker that this is not necessarily so. Traditional GAAP places servers and networking gear in the bucket of long term assets along with things like buildings, bulldozers, cranes, heavy machinery, etc. For a hosting company, this placement just doesn't make sense.

Long-term assets, or capital assets, are things that typically can't be reconfigured, can't be easily converted into cash, and are used for a long period of time. A hosting company's, buildings, generators, HVAC gear, etc., is rightly classified in long term assets. But servers and networking gear are quite different in that they exhibit more traits of current assets than long term assets. Check out this definition. It would take far less than a year for a hosting company to convert its server fleet and networking gear into cash and these assets are the key source of funds for day-to-day operations.

A manufacturing company gets to count its inventory in current assets, whether it is raw materials, work in progress, or finished goods ready for sale. A hosting company uses its servers and networking gear in much the same way – it can reconfigure the processors and drives of servers, arrange the networking gear to offer new services, virtualize a server into several virtual machines or combine several servers into a grid. Then it can change things up next month if desired. This sounds more like current assets than a bulldozer. But according to GAAP and the 800 year old double-entry math system we must use today, servers get placed in the same bucket as bulldozers.

My question is, how do hosting companies as an industry get together and establish some specific accounting standards that will allow our financial statements to truly reflect our business? Simply moving servers and networking gear to current assets would more accurately reflect how we use them in our business.

Am I off base in asking this? Hardly. The real estate investment business has been doing this for years. Traditional GAAP simply made no sense to their business, and they developed accounting standards that fairly represent that business. See this and note this quote from the Real Estate Information Standards, which is published by the National Council of Real Estate Investment Fiduciaries and is widely accepted among the real estate investment management industry and the firms that audit that industry:

"The development of the Market Value Accounting and Reporting Standards resulted primarily from the realization that standardization of meaningful financial reporting was necessary in order to allow real estate to become more acceptable as an institutional investment asset class. Accounting standards promulgated by authoritative accounting bodies exist for various real estate entities, including public real estate investment trusts and other public and private real estate entities that utilize historical cost accounting [i.e. GAAP – my comment]. The reporting requirements and information expectations of the institutional real estate investment community required the development of a market value-based financial reporting model for which no accounting standards published by authoritative accounting bodies presently exist. Accordingly, the lack of adequate authoritative guidance applicable to market value accounting for institutional real estate investment vehicles necessitated the need for these standards to be published."

Translated out of accountant-speak, this simply says that GAAP didn't fit their business and they applied common sense to the situation. I suggest that this young business of web hosting also needs some industry specific accounting standards to fairly report information about the health of its companies to its investors, and that these standards do not presently exist. Finally, if you've made it all the way through to here, you may order a server with free double RAM up to 2 GB by using the promo code "toothpaste&OJ" anytime over the next week. [subject to approval by Lance of course]

-Gary

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