No business in this world happens without money. At any given point, an entrepreneur should know his business worth and financial position – strengths and weaknesses. Such information can empower small business owners to decide what’s best for their firm and avoid expensive mistakes like too much debt or a cash crunch. Where can you find such information? Your balance sheet tells a lot about your business. It gives you a quick view of your company’s financial standing in the short and long term, how much you have (assets) and how much you owe (liabilities).
Benefits of Analysing Your Balance Sheet
Most small businesses fail in the first five years of operation as they make some common mistakes. Many businesses run out of working capital as they fail to manage cash flows, expand too fast, store excess inventory, or take too much debt. You can avoid these mistakes by updating your balance sheet to understand the risks and returns before making significant decisions. Your balance sheet can help make informed working capital, asset performance, and capitalization structure decisions.
This article will tell you how small business owners can make the most of their balance sheets.
What Does Balance Sheet Say About Working Capital of Small Businesses?
Your balance sheet shows your current assets (cash reserves, asset receivables, and inventory) and current liabilities (short-term loans, tax payable, accounts payable). The working capital ratio tells you whether you have enough liquidity to pay your short-term liabilities.
Working capital ratio = Current Assets/Current liabilities.
Amy is a baker with $2,000 in cash, $3,000 in accounts receivable, $3,000 in accounts payable and $1,000 in loan repayment. Her business has a working capital of 1.25, or enough liquidity to pay near-term financial obligations. But this alone is not enough. If she doesn’t collect the $3,000 receivables in time, she won’t be able to meet the payables, leading to payment delays. Hence, Amy uses a cash conversion cycle to determine how many days it takes for her business to convert her inventory into cash.
Cash conversion cycle (CCC) = days of inventory outstanding (DIO) + days of sales outstanding (DSO) – days of payables outstanding (DPO)
As Amy is a baker, her inventory is perishable. She needs to maintain a short DIO (number of days inventory is in stock). The smaller gap between payables (in how many days she pays suppliers) and sales outstanding (how efficiently she collects money from clients) will keep her cash flows efficient and prevent her business from falling into a cash crunch. Amy’s CCC increased in the third quarter due to inefficient collection of receivables. This warning signal helped Amy act on it and follow up with clients and negotiate terms to accelerate receivables.
How Can Small Businesses Analyse Asset Performance Using Balance Sheets?
A fixed asset like equipment, car, or property can take away a significant amount of capital from your business. Hence, you must be sure that this asset will give you sufficient returns that justify the investment. Your balance sheet also gives you a snapshot of your fixed assets and how they improve your business performance (revenue or earnings).
The two asset performance ratios tell you how efficiently your business uses the existing assets.
- Fixed Asset Turnover = Net Sales/Average Fixed Assets
- Return on Assets (ROA) = Net Earnings/Average Fixed Assets
Businesses can use these ratios to decide whether to purchase, upgrade, or lease an asset. For instance, Amy’s bakery has two ovens. During Christmas, she faces a capacity shortage. Is it worth buying a new oven and a delivery van? Investing a large sum in an asset that won’t generate enough money to cover the cost could cost Amy her business’s future. How? If Amy takes on debt and the asset doesn’t generate enough money to pay the monthly instalments, it could spiral into lower working capital and a cash crunch. A short-term solution could have long-term financial consequences.
The balance sheet will tell Amy about her bakery’s ROA, her working capital needs, and the amount (cash reserve) she can spare to buy a new asset. Amy decides to lease an oven and delivery van for a seasonal capacity shortage instead of buying them. Amy can also compare her ROA with that of her competitor and determine if she needs to upgrade to energy-efficient ovens.
How Solvent Is Your Business? The Ideal Capitalization Structure
Your balance sheet tells you how efficient your business is and how you should fund it. Many companies use debt to fund their operations. But how much debt is good and can help you sustain your business profitably?
If you had to sell off your assets and shut down your business tomorrow, how much money would you have after paying down all your debts?
Debt coverage ratio = (Current assets – inventory)/Current liabilities
A 1:1 debt coverage ratio tells you that your business can pay off the existing debt, and more debt could put you in a difficult position. At such times, it is better to talk to your business consultant.
The debt-to-equity ratio gives you an overview of your company’s ability to repay debt in the long term. Many companies use debt restructuring and accelerated repayments to reduce this ratio. Your business consultant can guide you on the most efficient way to strengthen your balance sheet.
Every business owner, big and small, should talk to a professional accountant and prepare a balance sheet to act timely before an issue becomes too big to handle.
Contact KSSP Partners LLP in Markham to Help You With the Balance Sheet and Other Accounting Needs
Talk to a professional accountant to help you prepare balance sheets and other financial statements accurately and regularly. At KSSP Partners LLP, our accountants and bookkeepers can keep your books of accounts updated. Our advisors can help you analyze these statements to operate and grow your business efficiently. To learn more about how KSSP Partners LLP can provide you with the best accounting and bookkeeping expertise, don’t hesitate to contact us online or by telephone at 289-554-5997.