What you should know about balance sheets
A balance sheet is a snapshot of your business’ financial health. It tells you how much money and other assets your company has, and what it owes to creditors or others. In this post, we’ll cover the basics of understanding a balance sheet so that you can know if your business is in good shape financially.
So what does a balance sheet show?
A balance sheet is a snapshot of what a company owns and owes.
The first step in reading your balance sheet is breaking down the different sections and what they represent. A typical balance sheet will show Assets less Liabilities equals Net Assets or Owners Equity.
Source: smallbusiness.wa.gov.au
The Assets Section
Assets are things the company owns. Assets include cash on hand, inventory (products ready for sale), accounts receivable (money owed to the company) and property or equipment (items like computers).
The Liabilities Section
Liabilities are things the company owes. Liabilities include loans from banks or other creditors as well as accounts payable (money owed by the company). The total amount of money owed to all creditors is known as debt (liabilities).
Current and noncurrent
Why would we have current and noncurrent sub categories in assets and liabilities? It seems like an unimportant distinction, but it actually has a big impact on your company’s financial position. The reason that we make this divide is because we want to be able to evaluate the liquidity of the company.
Generally, any assets that can be converted to cash and liabilities which might be settled within one year are regarded as current and noncurrent if they would have taken more than one year. As you can see the distinctions in the example above.
So we have the liquidity of a business as followed:
Working Capital = Current Assets – Current liabilities
The Equity Section
Equity is the difference between assets and liabilities; it’s also called net worth or shareholders’ equity.
Thus, we’ve the accounting equation.
Equity = Assets – Liabilities
Or another way of looking at it
Assets = Equity + Liabilities
Why do companies produce balance sheets?
There are many reasons why you as a business owner might like to use balance sheets.
They provide a snapshot of your company’s finances, and it can help you identify strengths and address potential issues before they arise. Here are some of the questions you could ask when reading a balance sheet.
Is the average pay time for customers past their due date?
Are too many customers putting off paying until they’re contacted?
How are you doing with debt collection?
How can you get them to pay earlier?
Do you have too much inventory on hand?
Is cash flow tight but not enough that we need to take on debt financing yet?
Apart from being an important tool for internal assessment, the balance sheet is often prepared with other financial statements for some of the reasons listed below.
Applying for a business loan
Before a bank will extend you a loan, they consider all of your company’s financial statements. They look at the balance sheet, the income statement and the statement of cash flow because they want to see if you are able to pay back the loan. The bank also wants to know if it will be able to get its money back from you if something goes wrong.
Selling the business
Balance sheets tell a lot about your company. They can show how much cash you have on hand, and how well you use that cash and if you have enough to pay off debts.
A buyer of a small business would probably consider these values on your balance sheet.
Examine a company’s assets to determine if it has enough of these resources for business needs. Cash is critical because this will allow an owner to operate and maintain their business, which might be how they would make money in the first place.
A large accounts receivable on hand means that your business has already made sales but not yet been paid for by customers. If there’s a low number here then it can be assumed that few orders were placed which could indicate poor customer service or product quality issues.
What can affect a small business’ profitability?
What are the factors that may come into play when considering what drives your company’s success and how to achieve it? The balance sheet along with the profit and loss [link] and the cash flow statements can provide you the information to make informed decisions.
There are external factors for which you cannot control like market competition, consumer demand and industry regulations.
And there are internal factors that small business owners can identify and implement very quickly to increase profitability. The financial reports will help you to find these opportunities.
Price
The most common factor is price.
How are you pricing your products and services?
Your profit margin is a number that you should always think about because it indicates if you’re making money or if you have an attractive price.
Quality
What can you do better?
The quality of products and services can always be improved. We all should aim to provide a more reliable experience for all customers. Although we’re exchanging products and services for money, we’re in the people business as Brian Tracy says.
Why would the customer buy from you?
Customers buy products and services to solve their problems, so the quality standard has to meet their needs.
And they buy from small businesses that they can connect with. It’s the human interaction that drives them to you after all.
Productivity
Streamlining your operations is actually a simple process with just two steps: automate specific tasks and reduce time, manpower, and operating expenses to run the business. You can do this by putting repetitive activities by setting up systems and procedures in place.
Technology
Technology has changed the way small businesses operate. Technology has enabled small businesses to interact with their customers in a whole new way. Many companies are still able to serve those who come into the store, but many others can also reach more people online and have them book appointments through tools integrated on their website.
Team Members
Good management will help make your company successful. Your team members are your most important assets, you should motivate them and make sure that they enjoy working with you. If they feel they have a connection with you, it’s more likely they’ll connect with customers they serve. Staff morale will determine productivity and the level of dedication to their work.
In this blog post, we’ve covered what each section in a balance sheet says about your company and why it’s important for any size of business to understand what each category means.
Take some time today to look at your own balance sheet and see where there may be opportunities for improvement – whether new customers, more assets or higher profits!
We hope this article has helped you understand more about how a balance sheet works and given you some ideas on how best to use one in your own business management strategy. If not, we’re always happy to chat with our clients; just give us a call!
