Business owners and CEOs often overlook their balance sheets in favor of the income statement, or profit and loss (P&L) statement, which is pillar of management. At a glance, the income statement reveals revenue, maybe gross profit, and net income.
Business owners can use the income profit and loss (P & L) statement to determine how accurate costs are based on job costing, gross profit margin and contribution margin. With the income statement, CEOs can measure performance by looking at the company's finances over a period of time.Income statements are also highly useful in strategic planning and goal tracking. If you have a budget you can compare total months, quarters or years to a company's performance over the previous periods. For all of its virtues, however, the profit and loss statement should not be allowed to completely eclipse the balance sheet.
At first glance, the numbers on a balance sheet provide only a brief moment of a company's finances, a snapshot of sorts. Whereas, the income statement reveals a company's financials over a period of time, more like a movie. With a series of snapshots, however, balance sheets can create a real-time stop motion animation which illuminates current trends in a company's assets, liabilities, liquidity and equity.
Knowing how to read your balance sheets will make it possible to watch the "motion picture" that is your business as it is filmed each day, week or month.
How to Make the Most of Your Balance Sheet
Reading a balance sheet is not intuitive.
Since it is a snapshot, today's balance sheet is completely different from yesterday's or tomorrow's. With the time required to reconcile accounts and prepare financial statements, the balance sheets you receive contain information which is likely at least two weeks old. With ever-changing account balances, payroll schedules, payables going out and receivables coming in, numbers can fluctuate significantly over only a short period of time. As a result, most business owners regard balance sheets as "old news" and pay them little attention.
Balance sheets, however, are really all about comparison.
When you understand this, you will understand how to unlock the potential of your company's balance sheets. Learn the following three keys to reading balance sheets to make the most of them.
1. Begin by Tracking Equity Trends
Equity is the summary and culmination of everything that happens in your company. Over time, it reveals how well you are managing your company's value. Use balance sheets, distributed at the end of each period, to track your company's equity, which is the net worth of the business.
Equity = Assets - Liabilities + Net Income
To determine whether you are growing or decreasing the value of equity in the business, plot equity on a graph where X = Time and Y = Equity, each time you receive a balance sheet. Whether the dots move up or down will ultimately reveal whether your company is successful and growing or losing money and facing potential difficulties.
2. Consider Changes in Assets and Liabilities
After using assets and liabilities to calculate equity, consider them individually. These numbers on their own will reveal to you where your company's cash goes each week, month or year. For example, if you have a period showing a profit, but still have cash flow issues, then your liabilities are likely growing more quickly than your assets.
You can determine whether or not your company is growing by comparing these numbers from balance sheet to balance sheet (perhaps also on a graph with a differently colored line for each). If assets increase more than liabilities, then the company is growing.
If liabilities increase more rapidly than assets, then the company is losing value (equity). With this simple comparison, you can quickly assess how well you are managing the business.
3. Determine Your Liquidity by Calculating the Current Ratio
The current ratio, also referred to as the working capital ratio, reveals a company's liquidity or its ability to repay debts (both long-term and short-term obligations) by comparing all of a company's liquid and illiquid assets to the company's total liabilities. This ratio reveals much more than simply looking at your cash on hand from a balance sheet because total assets in the current ratio also includes receivables.
For example, a balance sheet dated for the 31st might show only $100,000 available in cash at the end of the previous month. If that company, however, has one million in receivables due on the first from responsible clients, then this million is considered in the current ratio, revealing a much healthier cash position.
Calculated with up-to-date data taken directly from the balance sheet, the current ratio reflects the present liquidity of the company. It can be used to obtain a current idea of financial health and also to provide a guage for the efficiency of business operations (i.e. the cycle of converting products or services into cash).
Current Ratio = Current Assets / Current Liabilities
A current ratio greater than one generally expresses a healthy financial state. A ratio above one means the company has more assets than liabilities and should not have a problem repaying debts or covering expenses.
- For example, consider a company with $500,000 in current assets and $400,000 in current liabilities: $500,000/$400,000 = 1.25
If a company's current ratio, however, is a number significantly greater than one, this could mean that some assets are not being leveraged to their full advantage to grow the business or make distributions to stakeholders.
- For example consider a company with $500,000 in current assets and only $100,000 in debt: $500,000/$100,000 = 5
A current ratio less than one does not necessarily mean a business is doomed to fail. Depending on how far below one the current ratio is, it generally means the company faces the possibility of running into cash flow problems when repaying obligations or, with a low enough ratio, covering the significant cost of payroll.
- For example, consider a business with $500,000 in current assets and $600,000 in current liabilities: $500,000/$600,000 = 0.83
You will always know whether or not you have enough cash on hand to pay off immediate obligations by using your balance sheet to calculate your current ratio.
Maintain Consistent and Accurate Balance Sheets, P&Ls and More
When it comes to your company's financial wellbeing, accuracy and consistency are everything. Business owners without access to accurate financial statements must operate in the dark, making decisions without financial information. As a business owner or CEO, your ability to make data-driven decisions depends on having accurate, up-to-date financial information at your fingertips.
Accurate and timely financial statements allow you to track the key performance indicators which are vital to your ability to foresee potential cash flow issues, identify areas for growth and devise strategies for cutting costs.
Our financial strategy experts at GrowthForce can help you get your business finances on track by helping you establish a sound bookkeeping and accounting system, generating dependable financial statements and providing you with the necessary tools and guidance to use your financial information to make smart, data-driven decisions for your company.