A business’ Balance Sheet is their report card. It tells the owner how well the business has performed and how well it is positioned to move into the future. There are several areas that you will want to receive high marks if you are wanting to remain healthy and successful. Your balance sheet measures your assets, liabilities and equity. The numbers should indicate a healthy balance between assets available for use and the liabilities incurred to own them.
The Balance Sheet is actually a more critical financial tool that the income statement. The income statement is more static and provides less information than the balance sheet. The income statement is for a particular period of time and provides only revenues and expenses. The balance sheet indicates how well the business has performed since it inception; how well a company is positioned to remain in business, how well the assets are utilized to generate income, it holds a wealth of information as soon as you know what to look for.
Before you use your balance sheet as a barometer for your business, you have to know what a healthy balance sheet looks like and you need to ensure that yours is as accurate as possible. Accounts need to be reconciled so that you know what you are looking at is telling you the correct story. Balance sheets vary between industries and may not look all that similar. You should look at other balance sheets of typical companies in your industry. No matter how large or small, companies have the same problems and issues and this comparison will help you determine how you stack up within your specific industry. Then you can take a hard look at what kind of shape your business is in.
Let’s take a look at some of the major components of any balance sheet.
Cash is King: Do you have enough cash or do you experience frequent cash flow problems? Everyone knows that too little cash is not good, but too much cash is also a problem. Excess cash should be put to better use that just sitting in the operating account. If there is no debt to be paid off to avoid interest charges, then the cash should be put into short-term investments to generate additional income. Given that interest rates on savings is so low these days, paying off credit card debt and other kinds of debt, if you have it, is the best use of excess cash. Before you go debt free though, make sure you have a line of credit that will allow you to borrow against it in the future should you need to. Don’t give up your cash now if you will not be able to qualify for loans later. Get lines of credit approved while you are healthy cash and profit wise so when hard times come, you have the line of credit to go to. You won’t be approved for a line of credit at the time you need one most. Get healthy and then put one in place for future or temporary uses.
Accounts Receivable: As with cash, just having a large balance in accounts receivable is not enough. You need solid accounts receivable, not accounts that are consistently past due. You and your A/R aging report should meet every week to keep yourself current on how much of your receivables are past due. The sooner you attack accounts that are late paying, the sooner you get paid. Again, your industry information may tell you long it takes the average company to collect. You want to be at least as good as the average. The longer you wait, the more stale accounts receivables get, the harder it is to collect and the more chance you have of not getting paid at all. Consistently be the squeaky wheel that calls as soon as an account reaches a certain past due point and companies will get trained to pay you in a more timely fashion. If you never bug them about being late paying, they take it as their own personal credit plan with you. Have a policy that you call as soon as a receivable is 5 days past due and every week after that until you are paid. The person handling accounts payable will get sick of hearing from you and pay you sooner than they will pay people who do not bother them.
Inventory: An accurate inventory balance is critical, especially at the end of the year. You will want to know how you value your inventory, LIFO, FIFO, weighted average, etc. You will also want to know if you have any items that have been in inventory for an unreasonable amount of time. If this is true, you will want to understand why. Is it damaged, obsolete or just not selling. You should make appropriate adjustments if items are damaged or obsolete. You may want to reduce the price to get them off the shelves. With so many ways of selling stuff online today, you may find a customer looking for exactly what you have to sell and you can at least make a small profit, get the items off your shelves and/or get some reimbursement of the original expense of buying them which will allow you to invest in items that will sell. If there is no way to convert inventory to cash, you can also consider donating certain items to the appropriate charity to get a business deduction of their cost if all else fails. You won’t get any cash, but a deduction for their cost will lower your taxes which is the same as cash, albeit less than you would have chosen.
Fixed Assets: In this area, you will want to look beyond the numbers. The proper way of keeping track of your assets is to record them at their original cost and then depreciate them based on an appropriate depreciation life and method. Because of these record keeping methods, the asset values on your balance sheet do not reflect their current or real value. To know what value you have hidden in your assets, you will need to come up with an estimate of the current market value for each asset, taking into account reductions for wear and tear and obsolescence. Advance technology makes obsolescence more common, especially for computer systems. In these cases the recorded value many not be representative of current value. Keep in mind that you cannot book your assets at their market value, you can only book them at their original cost minus the appropriate depreciation, but knowing their market value will assist in knowing what your assets are really worth, good or bad. If you have assets that are no longer used, get rid of them. Sell them, scrap them, donate them. Get rid of the clutter and make room for assets that can help you generate income.
Liabilities: You should always monitor how much you owe other people. If you cannot stay current on your liabilities, then that is an indication of a problem that needs to be addressed. When you are always behind on your debts, then you are constantly using current profits to pay off old debts and it is tough to get out of that vicious cycle. You should never finance assets that have a useful life of 5 years with debt that is 10 years. The life of the asset you are purchasing and the life of the debt incurred to buy it should be about the same. Otherwise, you are still paying the debt of buying an asset after it has ceased being able to generate income for you. I think this is a common mistake companies make. They think that extending the debt as long as possible is the smart thing to do and, in fact, it is not. The reason you own assets is so that they can be used to generate income. If you are still paying the debt off once the asset has ceased being able to generate income, then your debts will grow out of proportion with the assets that generate the income used to pay off that debt. Current assets should be leveraged with current debt, mid-term assets should be leveraged with mid-term debt, and so on.
Equity: The most important thing to remember here is that retained earnings is not the same as cash. A company may make a good profit and still have no cash in the bank. Retained earnings are the company’s lifetime net income minus any dividends or distributions taken. Even though this may be more than zero, some of it has been invested in assets or used to make other capital expenditures. This section will tell you how profitable you have been over the years and will indicate how much of the profits have been retained in the company; but it is not a reflection of the amount of cash you have. The value of your assets, the amount of debt you have all affect how the equity section of your company will look. Many companies wonder why they cannot get a bank to loan them money when they have a profitable business. It is often because the owners do not maintain any equity in the company. They take every dollar they can and make distributions to themselves. Therefore there is little cash and no equity in the company. A bank does not want to invest in a company whose equity is taken out by the owners until there is little left to fund future operations of the company.
The more you know about the components of your balance sheet, their obvious and hidden meanings, the better you will understand your business and what drives its ability to remain successful, its ability to fund future growth, etc. Don’t lose a sense of the big picture while you lose yourself in the day-to-day running of your business. You will make better decisions regarding the future of your business if you are current on the financial status of your businesses financials statements.
Discuss your balance sheet with your accountant or a trusted banker and you will learn a lot. Don’t assume your business is progressing, get the real scoop and stay on top of your numbers for the best way to make decisions.
O’Connor & CO CPAs is a full service accounting firm providing professional services to individuals and small to medium size businesses. Call today to discuss your needs; 303-623-2676