Using Your Balance Sheet to Empower Decision Making
Many business owners are pretty savvy when it comes to their income and expenses, but completely in the dark with the ever-mysterious balance sheet.
When set up properly and updated timely, your balance sheet provides a plethora of valuable information to help make critical business decisions.
How To Read Your Balance Sheet
Let’s take a look at the information your balance sheet has to offer. The basic balance sheet is divided into three sections — assets, liabilities, and equity.
Assets are listed on the balance sheet first. Assets include your cash, investments, inventory, receivables, and fixed assets. These items have a positive value for your business.
The assets are further divided between cash and cash equivalents as well as current and fixed assets.
Cash and cash equivalents include funds in your bank accounts plus stocks and other securities in your investment accounts.
Current assets are receivables and inventory which will be converted to cash during the next twelve month period.
Your furniture, fixtures, buildings, and land are considered fixed assets and separated from the other asset classes as these items are less liquid, or less easily converted to cash than invested securities and current assets.
Liabilities come next. These items represent all of the amounts your business owes others.
Liabilities are also divided into current and long term liabilities. Unpaid bills, taxes due, and short term loans are classified as payables and make up the bulk of your current liabilities.
Prepayments by customers for products not provided or work not yet perform would also be included in your liabilities as unearned revenue since these funds may be refundable to the customers if the order is not completed.
Long term liabilities, due beyond twelve months, consist of longer-term loans and mortgages, capital leases, and pension or retirement liabilities, to name a few.
The final section on the balance sheet is equity. The first component of equity is the capital contributed either at startup or through additional investments in the company less any shareholder dividends.
The second part is retained earnings comprised of the year over year cumulative net income. The equity section on the balance sheet represents a basic calculation of your company’s net worth.
Using Balance Sheet Ratios
On a balance sheet assets must equal the sum of liabilities and equity. While a Profit & Loss statement (also known as a P&L) provides information over a range of time such as a full month or year to date, the balance sheet provides a point in time look at a company’s financial position since its inception.
Now that we understand the components of the Balance Sheet, let’s talk about how it can provide value in making critical business decisions. With a correctly structured report, a number of easy to calculate ratios can be very useful to any decision making process:
- The Current Ratio = Current Assets divided by Current Liabilities
- The Quick Ratio = Current Assets less Inventory divided by Current Liabilities
- The Debt to Equity Ratio = Total liabilities divided by Total Equity
Each of these ratios has different functions and help you make different decisions.
The Quick Ratio And The Current Ratio
These ratios provide a good measurement of your company’s liquidity. A ratio greater than one indicates the company has enough liquid assets to cover current liabilities.
A higher current ratio means a company has a higher ability to pay off short term debt obligations. A ratio below one may signal that the company does not have enough liquid assets to pay off short term debt.
The quick ratio is a measure of assets that can be “quickly” converted to cash since not all inventory is as liquid as other current assets.
The Debt to Equity Ratio
The debt to equity ratio provides another view into a company’s financials by expressing how much debt the company has compared to its capital and retained earnings.
A value above one indicates the company has more outstanding debt than equity. Since many businesses grow by taking on debt for expansion or acquisitions, a ratio greater than one is not necessarily a bad sign.
Understanding the terms, required payments and cost of the debt will show you if the current debt is a benefit or a burden to your growth and profitability.
Reviewing these ratios can provide a good look at the health of the company. An understanding of balance sheet components used to calculate the ratio components will enable you to devise “what if” scenarios for your business.
For example, determining that 25% of the current receivables are not collectible or choosing to take on a short term loan can be incorporated into the ratio calculations to demonstrate how liquidity will be affected by these decisions.
Aging Reports and The Balance Sheet
Reviewing both the receivable and payable balances is another method to aid your decision making.
Receivables represent the amount of credit you are providing for your customers who are invoiced for the goods and services you provide. Current liabilities represent credit extended to you by your suppliers, contractors, or the government.
It’s important to understand what these balances represent in terms of days outstanding by using the balance sheet along with an aging report.
An aging report demonstrates how your receivable or payable balance breaks down by 30, 60, and 90 or more days outstanding. The longer an account receivable is outstanding the less likely it will be received thereby turning the balance into a loss for the company.
Longer payable balances may result in late payment fees and interest expenses. Staying on top of these balance sheet items will help you avoid unnecessary expenses.
A regular review of your full balance sheet is needed to ensure your company is healthy and viable for the long term. Comparing balance sheet items at different points in time will help you understand if your company is growing toward success or if problems are arising.
Monitoring your balance sheet can help you tackle any issues before impacting your company’s profitability and overall health.
Arrow Cloud Bookkeeping offers resources to aid in your understanding of your own company’s balance sheet, leading you to greater growth in your business.