Knowing your numbers is vital to business success. The Balance Sheet is arguably the most important report, as it measures whether your business’s worth is increasing or decreasing. It illustrates the overall financial health of your business; whether it is funded appropriately, if there’s enough cash to pay the bills, and what the owners would have left if it was wound up tomorrow.
Profitable businesses can, and do, go broke if they have a weak Balance Sheet.
Three common scenarios:
1. Growing sales without an efficient billing or collection system.
This can result in a situation where you don’t have enough cash to pay your bills.
2. Borrowing too much money to finance the business.
If there is a downturn in sales, you could have a situation where you can no longer service your interest and principal repayments (even though you’re still making a profit).
3. Taking too much out of the business.
It could be as simple as earning a profit but not leaving enough to pay for tax and asset replacements.
Some critical things to understand:
1. Do you have enough working capital?
Calculate working capital by taking your current assets (e.g. customer receivables, inventory, and cash) less your current liabilities (supplier payables, taxes, and loans due within one year). If the number is negative, you’ll experience cashflow strain and weaken your business.
2. How long is it taking to collect your customer receivables?
Calculate this by dividing the total customer receivable amount by your total sales for the year, then multiply the answer by 365. This tells you how many days it is taking you, on average, to collect your receivables. The lower the number the better. Compare this number of days to your normal trading terms on your invoices.
3. How many times are you turning over / replacing your inventory each year?
Divide the total direct material or product costs by the inventory amount. You can do the same calculation on individual products by taking the total cost of a product sold divided by the cost of that product. The higher the number the better, as you are converting that stock into cash more quickly.
4. Is your shareholder current account an asset or a liability to the company?
If it’s an asset, this means you owe the company money, which needs to get fixed!
5. What return are you getting on the assets you’ve invested in?
Net profit divided by the value of total assets gives your % return. This percentage can be compared to likely returns from other investments to determine how well your business is performing.
The list goes on and will depend on your type of business. Having real time data for your reports will make your financial health diagnosis more relevant than relying on your last set of annual financial statements that could include data that is up to 18 months old.
Some of the calculations above are simplified to reinforce the message (instead of getting into complex “Accountanese”). Talk to us about how strong your Balance Sheet is and how we can work together to make it stronger.