Do you understand the story your Balance Sheet tells about your business? It’s important you understand the components of your Balance Sheet and the key ratios that measure the health of your business.
1. It measures the net worth of your business.
You Balance Sheet is made up of all of your assets and liabilities; your net worth is your total assets less total liabilities.
- Current assets are assets which are expected to be converted into cash within 12 months; current liabilities are expected to be paid within 12 months
- Non-current assets aren’t expected to be converted into cash in the short-term; non-current liabilities are long-term liabilities which aren’t expected to be paid within 12 months
Your net worth is the owners’ interest in the business. In other words, if your business was to be wound up this is how much you’d be left with as the owner of the business
2. It tells you if your business is solvent.
Solvency is the acid test for survival. If your business is insolvent, without immediate action to remedy this, it’s unlikely to survive for long. There are two components to solvency:
- Current ratio greater than 1 (current assets / current liabilities)
- Positive net assets (total assets – total liabilities)
If your business is insolvent, you’ll struggle to pay bills on time and you may be personally at risk. It’s imperative you seek help immediately if your business is insolvent.
3. It allows you track the strength of your business.
By comparing your Balance Sheet to previous periods, you can track whether your net worth is increasing or decreasing. The stronger your Balance Sheet, the easier it will be for your business to survive a downturn. For example, if your retained earnings are diminishing over time, it’s clear that you need to take action to strengthen your Balance Sheet to ensure you’ll receive value upon the wind up or sale of your business.
4. You can calculate key ratios.
Key ratios not only allow you to compare your results year on year or to industry benchmarks, they also highlight areas for improvement.
For example, calculating your debtor days may show that it takes on average 35 days for customers to pay you. If your payment terms are within 7 days of invoice, it’s clear that your debtor processes need to be strengthened.
Perhaps you calculate how long it takes inventory to sell and see it’s taking twice as long to sell this year than it did last year. Or, maybe a specific product is taking a lot longer to sell than others, which may indicate you should discontinue it. Key ratios calculated using your Balance Sheet can tell a us a multitude of things.
Every business owner should be able to read their Balance Sheet and understand what it’s telling them.
If you need help demystifying your Balance Sheet and identifying key areas for improvement, get in touch now!
Understanding Key Components of a Balance Sheet
A balance sheet consists of three main components: assets, liabilities, and equity. Assets are what the business owns, liabilities are what it owes, and equity represents the owner's interest in the business. Understanding these components helps business owners assess their financial position and make informed decisions.
For instance, current assets, such as cash and accounts receivable, are crucial for short-term financial health, while non-current assets, like property and equipment, contribute to long-term stability. Similarly, distinguishing between current and non-current liabilities can help identify immediate financial obligations versus long-term debts, providing a clearer picture of the business's financial structure.
Importance of Regular Financial Analysis
Regular financial analysis is essential for maintaining a healthy balance sheet. By frequently reviewing financial statements, business owners can identify trends, spot potential issues early, and make necessary adjustments to improve financial performance. This proactive approach helps in sustaining business growth and avoiding financial pitfalls.
For example, comparing your balance sheet with previous periods allows you to track changes in net worth and assess the effectiveness of financial strategies. If your analysis reveals a decline in retained earnings, it may signal the need for cost-cutting measures or revenue enhancement strategies to bolster your financial health.
Common Ratios Used in Balance Sheet Analysis
Key ratios, such as the current ratio and debt-to-equity ratio, are instrumental in evaluating a company's financial health. The current ratio, calculated by dividing current assets by current liabilities, indicates whether a business can cover its short-term obligations. A ratio greater than one is generally considered healthy.
In addition, the debt-to-equity ratio provides insight into the company’s leverage, showing the proportion of debt used to finance assets relative to shareholders' equity. A lower ratio suggests a more financially stable business, while a higher ratio may indicate increased risk, especially in volatile markets.
Strategies to Improve Your Balance Sheet
Improving your balance sheet involves strategic planning and execution. This can include reducing liabilities through debt repayment, increasing assets by reinvesting profits, or optimizing inventory management. Each of these strategies contributes to a stronger financial foundation and enhances overall business resilience.
For instance, implementing better credit control measures can accelerate cash flow and reduce debtor days, while investing in profitable projects can lead to asset growth. Regularly revisiting these strategies ensures that your balance sheet reflects a robust financial position, ready to withstand economic challenges.
