Sat Oct 10, 2020 | | Business, Cash Management

What You Should Know About Your Balance Sheet?

financial insights

Many business owners receive a monthly or quarterly balance sheet but do not frequently analyze it or know what to look for. Many owners do not understand why the balance sheet is essential.  Sometimes companies pay someone to prepare a balance sheet, and it’s another item that just sits in their inbox.

What Is A Balance Sheet? 

A balance sheet gives you information related to your company’s assets, liabilities, and equity at a given point in time. It provides your business with specific details about what you own, including what you are due to collect from clients and customers,  what you owe to vendors and creditors at a specific time, and the company’s net worth. 

Why Is A Balance Sheet Important?

Not only does this information help you make informed business decisions, but this data is also critical to the future of your business as it relates to investors, creditors, and lenders. 

For example, let’s say you decide that you want to expand your operations and need a loan from a bank.  The balance sheet will be one of the reports that the bank will ask for before determining whether or not they will lend to your business. The bank will now be able to see how much cash you have, how much debt you have, and whether they believe you will be able to pay back the loan.  

Similarly, suppose you are seeking an investor. In that case, they will also want to see a balance sheet to evaluate whether they will be able to ultimately get their investment back and earn a reasonable return on their investment.   They will also want to compare how much you own (your assets) to how much you owe to creditors (your liabilities) to ensure the amount you will collect is greater than the amount you will payout. 

What Should You Look For On Your Balance Sheet?

Assets: This is anything that you own. Common examples include your cash, accounts receivable (money owed to you not yet collected), equipment, inventory

Liabilities: Anything your business owes to suppliers and other creditors.  Accounts payable and debt are the two most common.

Working Capital: This measures your company’s ability to pay its short-term obligations.  Working capital is the difference between your company’s current assets and current liabilities.  In other words, this tells the business the number of assets remaining after short-term liabilities have been paid.  The higher the number, the better.  In this context current or short-term means assets or liabilities that are owed or to be paid in the next twelve months.

Current Ratio:  Similar to working capital, the current ratio also provides information about whether you can meet your short-term financial obligations.   To determine it, divide your existing assets by your current liabilities.  A current ratio below 1.0 tells a business they do not have enough assets to cover their short-term debt. An excellent current balance is at least between 1.2-2.0, which means that the company has about two times more current assets than current liabilities to cover its financial responsibilities.

Debt to Equity Ratio: This ratio compares your company’s total debt to total equity.  In other words, it shows you the percentage of financing from creditors and investors. To calculate this, divide your total liabilities by your total equity. A good debt-to-equity ratio is typically 1-1.5. However, every industry has different debt-to-equity averages as some trades use more financing than others.  A lower debt to equity ratio means your business is more financially stable. Companies with a higher debt to equity ratio are riskier to investors and creditors.  

How Often Should I Review My Balance Sheet?

The best practice is to prepare a monthly balance sheet for review.  This will give you ample time to change your business strategy if you are veering off course.  In addition, comparing your balance sheet from one accounting period to another or from the prior year allows management to see trends that assist in making business decisions or adjustments to strategies. A balance sheet that shows a comparison from one period to the next is called a comparative balance sheet.  

If you are having trouble understanding your balance sheet, please do not hesitate to contact us here.