The Balance Sheet: A Critical Tool for Measuring Your Business’s Health

Warren G. Purdy -- Expert Business Source, 2/16/2007 12:31:00 PM

When most small business owners are asked, “What are the three most important financial reports for your business?” they are likely to respond, “Cash flow, cash flow, and cash flow.”

The reason is simple: The cash flow statement helps you to predict when money will be available to pay your bills, salaries and other business-critical items. There are, however, other financial statements and reports that can provide equally valuable insights into the business and the factors affecting your all-important cash flow. Certainly one of the most important but often overlooked financial statements (except by your accountant) is the balance sheet.

• What is it?
  In a simple sense, your balance sheet is a snapshot of your business at a given point in time, usually at the closing of an accounting period. The balance sheet is based on the equation: Assets = Liabilities (Amounts Owed) + Equity (Net Worth). Assets are divided into the categories of short term (less than a year) and long term (e.g., cash vs. equipment), as are the liabilities (e.g., accounts payable vs. mortgage payments due in more than a year). The difference between the two is equivalent to your equity, or the value of your ownership in the business.
• What types of information can a balance sheet provide?
  The balance sheet holds a treasure trove of information that you can analyze in a variety of ways:
  • Data can be used to measure growth, operating efficiency, profitability and valuation
  • The balance sheet reflects the amount of cash and liquid assets on hand and the amount of accounts receivable for future cash flow
  • It helps you quickly get a handle on the financial strength and capabilities of the business. (i.e., are you in a position to expand?)
  • Comparing balance sheets over a period of time will help you spot important trends and make better management decisions.
• How do I turn balance sheet data into useful information?
  You can make a number of calculations (often called ratios) that assist you in making decisions. Several of the more common ones follow:
  
  • Current Ratio (or Working Capital Ratio): This is an important indicator of the financial health of your business.Divide total current assets by total current liabilities. A ratio of less than one is usually an indicator of a business in financial distress. A ratio between one and two indicates that the business is in a strong position. A ratio of more than two can mean a business is carrying excess stock or is not managing its cash and accounts-receivable resources efficiently.
  • Quick Ratio (or Acid Test): This is a variation of the current ratio. It lets you know if you have enough short-term assets to pay your liabilities without selling off your inventory.The quick ratio is calculated by taking the sum of current assets minus inventory and dividing by current liabilities.
  • Inventory Turnover: These ratios measure how efficiently your company uses assets. Inventory turnover is calculated by taking the cost of goods sold (from your income statement) and dividing by your average inventory. If your ratio is 6, that means that you turned over your inventory six times last year.The higher the number, the better.
  • Collection Period: This ratio lets you know on average how long it is taking you (in days) to get paid. To calculate the collection period, you take accounts receivable and divide it by annual credit sales, and then multiply by 365 (days in a year).The lower the number, the better.
  • Return on Equity: This ratio shows how much your company is earning on your investment. To calculate Return on Equity, divide net income by the owner’s equity.

In conclusion, you should develop the habit of reviewing your balance sheet at least quarterly. This will enable you to identify both problems and opportunities in a timely fashion, rather than waiting until you meet with your accountant at tax time.

Warren G. Purdy is an Associate Professor at the University of Southern Maine and a consultant with Inc. Magazine’s Growth Strategy Consulting Group. He is also a Senior Associate with Marketing Services Associates.