Decoding Balance Sheets: Essential Rules for Entrepreneurs and Managers
Many small business owners never look at their balance sheet because it’s like a foreign language to them. They just leave it up to their accountant. I don’t understand how my car works so I leave it up to my mechanic. But I know I’ll be in big trouble if I don’t pay attention to the fuel gauge and the warning signals on my dashboard.
Just like your car’s dashboard, it’s important to understand the basics of your balance sheet. It helps you monitor the health of your business and understand how outsiders, such as lenders or investors, gain insight into your business when they analyze your balance sheet.
Just focusing on a few key concepts will go a long way.
Here are three fundamental rules:
Rule #1: Assets = Liabilities + Equity
This simple equation is why it’s called the balance sheet. It’s always in balance because it tells the story about how your assets are financed. This is known as the capital structure of your company.
Think about owning a home. The home is an asset, the mortgage is a liability, and equity is the difference. You can have a more modest home than your neighbor but be in a much better financial position if you aren’t straddled by debt. It’s similar in a business.
- Assets: The definition of an asset seems fairly intuitive, but the term has a specific definition in accounting. Assets are probable future economic benefits owned by the business as a result of past transactions. It includes cash, accounts receivable, inventory, and long-term assets such as equipment and furniture. You often hear people say their employees are their most important asset. While that may be true, you wouldn’t see employees on the balance sheet because they are (thankfully) not owned by the business.
- Liabilities: Simply put, liabilities are the company’s obligations. The accounting definition of liabilities are debts or obligations from past transactions that will be paid in the future with assets or services. Liabilities paid with cash include accounts payable, accrued expenses, and debt. Deferred revenue is a liability that is satisfied by delivering goods or providing services.
- Equity: This is what’s left over; it represents ownership. This is similar to the equity in a home. On a business balance sheet, there are two parts to equity: 1) Amounts invested by owners as capital contributions or stock sales (like the down payment on your home), and 2) retained earnings (like an increase in the value of your home). Retained earnings is the amount of net income a company has earned since its inception that hasn’t been distributed to owners.
The equity section provides insight into your business because it shows how much owners and shareholders have invested in the company and retained for future investment.
Rule #2: Cash is King
We’ve all heard this expression. No matter what business you’re in, you need to keep an eye on cash. You can’t stay in business if you can’t meet your payroll or pay your suppliers. How much cash do you need to have on hand? Do you have too much cash? (Yes, that’s a thing!) A quick glance at the balance sheet can give you some clues.
The optimal amount of cash to have on hand is different for every business. In order to determine your liquidity and see if you have enough to meet your obligations, you can do a quick calculation.
Current ratio = Current Assets / Current Liabilities
Current assets are those that can be converted to cash within one year. The basics include cash, accounts receivable, and inventory. Current liabilities, conversely, are due within one year.
The current ratio shows if a company can satisfy its current obligations. A current ratio above 1 means that the company could pay all of their liabilities within one year. A current ratio less than 1 can signal a problem. Investors will compare your current ratio to the industry average to determine if there are any red flags.
Rule #3: Compare your balance sheet to the previous period.
Look at your balance sheet each month and compare account balances with the previous period. (QuickBooks tip: go to reports and run a balance sheet by month. Select the options under “compare another period” to see the change in dollars and/or percentages.)
Determine what’s important in your business and monitor those variances. For example, if you are a product company and managing inventory is critical, looking at a comparative balance sheet can be the first step in determining whether you have an issue. Do you have enough inventory to meet demand? Do you have too much cash tied up in inventory?
Which balances are growing month to month? Does it make sense that they are growing? For example, is your accounts receivable growing faster than your revenue? If so, why?
Are your liabilities growing faster than your assets? If so, is this temporary or indicative of a negative trend?
Is there enough cash to pay your current liabilities? If not, do you need to increase sales, improve collections or both?
Listen to your gut. If something doesn’t look right, ask your accountant for more information.
Don’t underestimate the importance of understanding your company’s balance sheet. Focus on a few key concepts and look at them regularly. Over time you will become comfortable with what they mean for your business.
ABOUT JUNA FINANCIAL SOLUTIONS
In order to be able to rely on this analysis and make smart, data driven decisions, you need accurate and timely financial statements. Contact us at Juna to find out how we can help prepare and interpret your reports.
