Four Urgent Questions Your Balance Sheet Can Answer
As a business owner, your accountant will likely provide you with several different types of financial statements. One of these is the “balance sheet”. Rows and columns of numbers will be displayed neatly next to their particular category, and given that your accountant is a whiz, you know it’s all correct. But since you’re the owner, not the accountant, you need to know how these numbers impact you now in order to make decisions on the ground. You have questions, urgent questions, that come up in the day-to-day management of your business. Are you prepared for emergencies? Is your business growing on pace with your goals? How will these numbers look to current and future investors?
Understanding how to read the balance sheet is important, but knowing what the numbers mean for your business, in the most practical sense, is exponentially more valuable. Keep reading to learn how the balance sheet can be used to answer your pressing questions about the health, wealth, and future prospects of your business.
A Quick Refresher: Assets = Liabilities + Owners’ Equity
If reading a balance sheet feels like trying to translate War and Peace from the original Russian, you may benefit from a more in-depth breakdown of the terminology. The U.S. Securities and Exchange Commission has a concise one here. As a quick refresher, your balance sheet is a snapshot of the financial position of your company at a certain point in time. It’s generally going to put Assets on the top, and Liabilities next and Owners’ Equity on the bottom.
The next obvious question is What do these numbers actually tell me? Below are four urgent questions you may have about your business, and how the balance sheet can help answer them.
#1: Am I prepared for unexpected expenses?
Like any smart business owner, you know that you need enough liquid capital to cover your normal expenses and running costs. But what if something completely unforeseeable occurs, like in 2020? This can be a natural disaster, a breakdown in a supply chain, an unexpected lawsuit…the nightmares that keep any responsible business owner grinding their teeth. Knowing whether or not you are solvent when faced with these unexpected expenses can help you sleep a bit more soundly. Click here for more on liquidity.
Your Net Working Capital is calculated by subtracting your current liabilities from your current assets, and it’s a great way to see how financially solid you are. Obviously, a positive amount of working capital means you’ll be able to pay your employees and suppliers in a timely manner, and anything over that is your easily-accessible rainy day fund. Now, determining how much working capital you should keep on hand is a conversation between you and your accountant, and can vary widely depending on your industry and business model.
#2: How is my business doing (compared to the competition)?
Another great calculation is the Current Ratio, which takes the current liabilities and assets we considered before, but this time divides the current assets over the current liabilities. This gives us a ratio. So if we have twice as many current assets as current liabilities, the ratio would come out to a straight 2.
In fact, a ratio of 2 used to be considered industry standard, but like linen leisure suits and shoulder pads with the wingspan of a 747, standards change. There is no ideal ratio for you, besides the individualized one that you and your accountant determine based on the unique aspects of your business.
What a ratio does provide, (far more clearly than the simple subtraction of Working Capital), is a way to compare your current assets/current liabilities on hand with other companies in your industry. A ratio is convenient because it doesn’t preclude comparison between companies of drastically different sizes. Comparing your ratio to other businesses can help you understand if you’re on par with the competition.
#3: How is my business doing (compared to last year, last quarter, last month)?
As we touched on above, the brilliant thing about a balance sheet is that it shows you how your business is doing at a certain point in time. This means, like an archaeologist digging up cross-sections of strata to compare the fossil records over the ages, you too can place balance sheets from different points in time next to each other to clearly understand your long-term growth patterns.
Ideally you have growth goals for your business, and comparing balance sheets from year-to-year, or quarter-to-quarter, is a simple way to confirm that you’re heading in the right direction. Unlike income statements, your balance sheet is an accumulated total, and lets you see the amount of growth one period-end to the next. Imagine your balance sheets as the tick marks made on a family’s wall to see how their child is growing. Juxtaposing these numbers can be an immensely rewarding exercise, and a concrete reminder of how far you’ve come.
#4: How attractive is my business to a potential future buyer?
You might have no intention of ever selling your business, but if an overwhelming offer comes along, you won’t want to be caught with your pants down.
When we discuss terms like Leverage, the equations get a bit more complicated. There are several different leverage ratios: two of the most common are your Debt to Equity Ratio and your Debt Ratio. These numbers can be important to future buyers, as they clarify how much of a company’s financial position depends on borrowed money. Click here for more on leverage.
Leverage is complex, and a higher amount of leverage in a business can be high risk, high reward. Therefore, a lower debt-to-asset ratio is often attractive to buyers, because it indicates that equity finances a larger proportion of the company. This means that their investments are more protected if the company ends up in financial trouble. If you have an open mind and are willing to entertain buyers at the right price, these are valuable ratios to wrap your head around and track.
Making the balance sheet work for you
When reading your balance sheet, it can be confusing to put abstract rows and columns of numbers into context even if you are fully aware of what they mean. The calculations above are simple ways your balance sheet can help you make informed financial decisions. If you have more questions about what your balance sheet and financial ratios mean for you and your business, you can reach out to Know Your Numbers Accounting any day of the week for expert advice.
As a business owner, how often are you looking at your balance sheet? Do you find it to be a helpful tool? Comment below and let us know!
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