The Balance Sheet: How to Quickly Analyse the Strength of Your Business
The Balance Sheet is an under-utilised tool in the management of small and medium sized businesses. Understanding what it tells us is the first step to understanding the information. If you have ever borrowed money personally from a bank you have almost certainly filled in a Personal Net Worth Statement, which showed what you owned and what you owed to come up with your estimated Net Worth. At its basics that is what the balance sheet is. It is the Net Worth Statement of the business showing what it owes and what it owns. The Balance Sheet is organised into events that will happen within 12 months of the date the Balance Sheet was prepared and those that will happen after 12 months (short-term and long-term, respectively).
When I first look at a Balance Sheet, there are three items that I quickly look at to get a first impression of the status of the business. First, I look to see if the amount of accounts receivable exceeds the amount in accounts payable. If they do, then there is a reasonable chance that the business is generating positive cash flow. Secondly, I look at the total of current assets (all those that will turn into cash within 12 months of the Balance Sheet date) and compare them to the amount of current liabilities (those items that will be paid within 12 months of the Balance sheet date) if the current assets are greater than the current liabilities then there is a reasonable chance that the business is solvent. The third thing I look at is the equity (I include any loans made by the shareholders to the business in this amount) to see if this is positive or negative. If this is positive the possibility exists for a base to support the existing operations and/or grow. This quick overview highlights areas that will warrant closer attention. I am now ready to look at the balance sheet in more depth.
An important point to keep in mind is that any analysis is only as good as the information upon which it is based. There are 5 key items that will help you analyse the strength of your business. The first items to come under my scrutiny are the accounts receivable. What I am looking for here are bad debts that have not been written off as well as any accounts receivable over 90 days old. Both of which will reduce the value of the accounts receivable. Why 90 days you may ask. Well the odds on collecting your receivables decrease rapidly once they hit 90 days. In fact, estimates range from a high of 50% to a low of 20% probability of success collecting these amounts. This adjusted number is the one I will use in my future calculations.
The next item to come under the microscope is the inventory. Here I am looking for old or obsolete items that now have reduced or zero values. These are referred to as old friends. If, as a general rule, you have held inventory for more than six months, it is now worth less than the amount you paid for it. This reduction in value includes an opportunity cost. An opportunity cost is how much money you have lost in the money tied up in the unsold item. For example, if your gross margin is 40% and you have $10,000 in unsalable inventory, then you have forgone $4,000 that you could have used to offset costs or add to your profitability. I reduce the inventory amount by the amount of old friends for the purposes of my calculations.
I do not change the amount of the accounts payable since these will all have to be paid at some point. What I do look for is any approaching 90 days or more, which might trigger action by the creditor against the company.
Having completed this exercise I recast the amount of current assets and compare them to the amount of current liabilities. As a general guideline, the current assets should be approximately twice the amount of the current liabilities or 2 to 1. Depending on the degree to which the business is cash based or credit based this ratio can vary a little. However, if it is less than 1 to 1 this is an indication that the business is encountering, or likely to encounter in the very near future, cash flow problems.
Another ratio I want to look at is the debt to equity ratio. Debt is the total amount of liabilities owed by the business. This amount is compared to the amount of equity invested in the business. This ratio is an indication of the businesses’ reliance on debt as opposed to equity. This is important because too high a reliance on debt can lead to the failure of the business. Too often when a business gets into trouble it tries to borrow money, which negatively affects the businesses’ cash flow instead of introducing additional equity which does not. Remember the faster the business grows the more equity it needs to support that growth. A reasonable ratio is that your debt should be about twice your equity.
Paying attention to these items on your Balance Sheet on a regular basis will help to ensure the ongoing viability of your business.