The Small Business Owner’s Guide to the Balance Sheet
In our work with small business owners and nonprofit directors, we find that many of them have a good grasp of their profit & loss statement, but typically they spend less time with their balance sheet. This is understandable. The P&L measures performance. That’s the more exciting issue. The balance sheet measures the impact of that performance on the company, which, although it is important, is much less exciting and certainly less timely or urgent.
This article explains the importance of a balance sheet and its use in a company. This article further details the balance sheet’s components such as assets, liabilities and equity.
Performance v. Condition
Watching a great athlete in the Olympics, everyone is focused on the result of the performance. Was it a new record? A personal best? Or, is it even enough to qualify? Did they lose a spot on the podium because of a mistake? No one is asking how that performance affected their heart rate, muscle mass, psychological frame of mind, etc. These are the things that will affect their ability to perform and keep performing in the future. We tend to favor a review of their performance over a review of the condition it has left them in.
Similarly, the month-to-month or year-over-year performance revealed in your profit and loss statement is compelling. Your monthly income statement answers some extremely important questions: Did we make a profit? Is it a new high? Did we lose money? Did we beat budget? These are important considerations.
But the balance sheet is where the results of this performance take their toll, for better or worse. The balance sheet shows you the condition your company is in as a result of your performance. This is a classic case of urgent v. important. The balance sheet is truly the most important measure of how your company is doing. But except for those times when we are seeking a loan or experiencing severe cash flow problems, the balance sheet rarely calls out for attention. The balance sheet changes incrementally, and you don’t really notice the impact that the changes are having on the health of your company until it becomes a crisis – usually related to cash.
Best practices call for us to review the balance sheet on a monthly basis. This paper will help you understand how the health of your business is reflected in this financial statement and share some ratios that will help you gauge the overall strength of your company from your balance sheet.
The Short Run: The Pressures of Cash
As you can see from the sample balance sheet below, your current assets are usually just cash and A/R, plus inventory if you have it. These are listed on the balance sheet in order of how liquid they are. The most liquid is cash, which is listed first, then the accounts receivable, and then inventory. The long term assets are the least liquid of all the assets - most are not and never will be liquidated. Often these are mostly depreciated and except for major machinery, real estate, or endowments, they have little impact on the running of the company.
But because current assets can be turned into cash, and cash is needed to run a company, current assets are perhaps the most important section of the balance sheet for a small enterprise. The liabilities are in chronological order of which needs to be paid first. Accounts payable and credit cards are usually listed first as those come due typically in about 30 days. Then perhaps a line of credit or some other short term borrowing is listed in the current liabilities, with long term liabilities coming last, since, apart from the current portion due, these loans do not present a sense of urgency.
There are two very important measures to look at related to the current sections of the assets and liabilities. The first is the liquidity ratio. The liquidity ratio for the balance sheet above would look like this:
Current Assets: $1,389,141
Current Liabilities: $372,204
Liquidity Ratio: 3.73
The liquidity ratio measures how much cash you have to work with to meet the short term obligations of the company. Our sample balance sheet shows that we have $3.59 of cash, A/R or inventory for every $1 of short term liabilities. The typical “healthy range” for the liquidity ratio is between $0.50 and $2.00.
This is perhaps the most important balance sheet ratio in running your business. Short term liabilities put pressure on business owners. Your long term debt will almost never put you out of business, it’s the current liabilities that cause the most trouble. Real estate developers can leverage millions of dollars in long term debt, but if they can’t pay their carpenters and subs every two weeks, they will soon be out of business.
Even if you have more than enough cash, the pressure is not off. Once the liquidity ratio gets above $2.00 of short term cash for every dollar of short term liability, then the question is, Why are we sitting on this cash? Cash should always be put to its best use, rather than sitting in the bank. The other measure of short term assets and liabilities is working capital. Along with the liquidity ratio, this is another look at the money you use to run the company in the short term, and to plan and invest for the long haul. That formula is simply current assets, minus current liabilities.
Working Capital Formula
Current Assets: $1,389,141
Current Liabilities: $372,204
Working Capital: $1,016,937
The Big Picture: Ownership and Control
The three sections of the Balance Sheet -- assets, liabilities, and equity -- are usually stacked vertically, but it is helpful to look at them in this fashion as it underscores the “balance” of the two sides.
The assets are owned or controlled by the entity which has the right to most of the assets.
The bank or the creditors may not literally own your company when you have a lot of debt to them, but they can exert a tremendous amount of pressure to control your actions, and control is really what ownership is all about.
For example, a company with a good deal of bank debt will be pressured to produce profits at the expense of higher sales. If this company is a distributor, they may be getting pressure from their suppliers to increase sales at smaller profit margins. These conflicting pressures remove control from the owner of the company and place it in the hands of the creditors.
The debt to equity ratio helps you understand what percentage of your company you own free and clear, and therefore it gives a sense of how much control you have. In the example above, we own 84% of the company. The debt to equity ratio would look like this:
Debt to Equity Ratio
D/E Ratio: 16%
Return on Investment: The Capital Structure of Your Company
This brings us to the bottom of the Balance Sheet: the long term liabilities and the equity. For a small business, these two sections of the Balance Sheet represent the capital structure of your company.
The capital structure is the money you use as investment capital to buy or support the assets of the company which you invest for a profit. This is opposed to the working capital which you use to run the business day to day.
Our sample Balance Sheet has no long term liabilities, which makes this a very strong balances sheet. The owner controls all of the capital structure used to support the assets: the best position to be in.
The return that your assets produce for you (and/or your creditors) can be summed up in the “Return on Assets” ratio.
Return on Assets
Net Income: $132,196
Total Assets: $2,656,552
This number shows in a direct manner the return you have achieved from the assets at your disposal. One can also look at the return on equity.
Return on Equity
Net Income: $132,196
Total Equity: $2,284,348
The equity section of the Balance Sheet can be the most difficult to read and understand in a small business. This is due to the many different ways that accountants and bookkeepers treat paid-in-capital, owner draws, and the like. But there are two lines in the Equity section that are very clear. The first is “Net Income.” This is just an annual running total of your profit for the year applied from your P&L each month. If you made $50,000 of net income in January, and then sustained a $10,000 loss in February, your net income line for the February ending Balance Sheet will read $40,000.
The other line, usually right above net income, is retained earnings. The net income keeps calculating your profit until December 31st, when it gets rolled into the retained earnings for the following year. Retained earnings only changes once each year on December 31.
Conclusion: The greatest value is “Off Balance Sheet”
Small business owners often look at their retained earnings after 20 years in business and say: “Is that all? Twenty years of my life and that’s all I have of retained earnings to show for it?”
Remember, the Balance Sheet does not contain everything of value in your business. Retained earnings do not fully express all the customers served, the employees whose lives were touched and taken care of by you, all the money you have taken out of the company and which has enriched your life.
Most business owners agree that their people are the greatest asset. It is the way in which you have touched the people whom you have interacted with in your business that determines whether or not you come out ahead.
Questions for Consideration:
- Do you review your Balance Sheet every month?
- Which of the Balance Sheet ratios have the most meaning for you and your business?
- What are the most important “off balance sheet” accomplishments of your business?