A balance sheet is a doctor’s chart - showing the financial health of a business.
Whether you do your own balance sheets or outsource it to your accountant or bookkeeper, it’s wise to be able to read it and read between the lines.
Here are some clues that you might not immediately notice in a balance sheet, whether you want to analyse it yourself or ask more educated questions of your accountant...
Financing of Customers and Suppliers
Running a business is an endless balancing act. One example is how long to give debtors to pay you. On the one hand, you want to be flexible and easy to work with (not just for business reasons, but to foster good relationships); but on the other hand, if you’re allowing someone 90 days to wait to pay you, that’s an interest-free 90 day loan.
Take a look at how long customers and/or suppliers are taking to pay you on the balance sheets, when they typically do so and whether it’s time to revise your terms of business.
Solvency Ratios - A Hidden Red Flag
Your solvency, as you probably know, is your financial security. It’s not uncommon to have some debt (you might have borrowed to get started, to buy new equipment, for premises, renovation etc) and your solvency ratio will show how much of your assets are financed by debt.
Your Debt to Asset Ratio = Total Liabilities divided by Total Assets. So once you divide these, you should get a low number: If you have the same amount of debt as you do assets, your ratio is 1 or 100%. If you have twice as many assets as debt, it’s 50%.
For a limited time, your ratio can survive 100% (i.e., all of your assets are financed from without, not from your own pocket). But unaddressed, even a profitable company can slide into the danger zone. So keep an eye on the debt ratio, making sure that you’re regularly paying off the debt’s principle.
Similarly, a Debt to Equity Ratio looks at how much finance is available, and how much of it is borrowed (debt) vs not borrowed (equity). It’s prudent to try to move as much as possible into the equity column and away from the debt side.
It’s not uncommon for companies to overlook their existing debt if they’re otherwise profitable and busy. And its level of danger to your business is often related to existing interest rates at the time: So if repayments are low (or even negligible), then there’s less time pressure; but compound interest debt can sneak up on a company.
Return on Equity
Again, this is something that can sneak past you, especially if you have a number of assets.
Return on equity = net income divided by total shareholders’ equity. In other words, this is how much money is being generated by the “equity”. Or how much money something makes vs how much it costs.
So every piece of equity you have, whether it’s a hay baling machine, a building to rent, or a coffee machine, should be generating money or (at the very least) not costing you or your business too much money.
Naturally, take into account seasonal factors: a convertible car is less likely to be rented in winter than summer, for instance. But again, assets sitting somewhere and not generating revenue should at the very least be checked up on.
One of the fastest ways to establish a company’s ability to meet its short term requirements is to look at its current ratio.
It’s a comparison of a company’s current assets (cash and receivables, within a year) to current liabilities. And it looks like this: Current ratio = current assets divided by current liabilities. In other words, what you have (in money, assets etc) divided by your financial obligations (bills, overheads, salaries etc).
Essentially, the ratio should be more than one (i.e., the number you reach when you work out the equation above). And it means that if you had to pay all of your obligations in one go, could you do so without borrowing? This is the kind of scenario that arises in emergency situations, which unfortunately have been quite common for businesses in the past year.
So maintaining a healthy balance of assets and equity, according to the equation above, is an ideal state that’s easily measurable.
Learning to Engage With Your Balance Sheet
Balance sheets are intimidating to any business owner, not just because they can be tricky to interpret at first, but also because they might be carrying bad news. But once you get over the initial discomfort and insecurity that comes with learning about balance sheets, they become your friends - the kind of friend who’ll bluntly tell you good or bad news, but who won’t hide the truth from you.
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