Current Ratio Punishes Hosting

September 18, 2007

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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