Going beyond your Profit & Loss Report - Understanding your Balance Sheet
Businesses with a strong balance sheet can take bold and timely decisions in a good economic climate and are more likely to survive difficult economic downturns. In a robust economy, a strong balance sheet means you can act on opportunities for growth and innovation, and likewise, in a downturn you have the cash reserves to call on if sales drop for a period of time, for example, or there is a market shock.
What does the balance sheet report?
In simple terms, the balance sheet is a financial report that details your business’ assets, liabilities, and shareholder equity. A balance sheet reports on working capital, defined as covering the expenses required day-to-day for the business to run like a well-oiled machine.
Cash flow is also reported on the balance sheet, with the aim of creating a positive cash flow or cash buffer in the business to withstand shocks and to invest in future growth plans.
The balance sheet also reports on any income generating assets a business may have.
Is my balance sheet strong?
When first starting a business, there is a focus on your profit and loss financial reporting, focusing on your business’ profitability and efficient management of your costs or overheads. You may not have focused too closely on your balance sheet in the first few years as a start-up or scale-up business, as you build your brand, client base and profit. But at some point it is important to consider your balance sheet, as it is an instrumental report when looking for investment or indeed, when you are considering selling your business.
Your balance sheet reflects the long-term health of your business, which in turn can attract interested buyers and investors.
How do you know if you have a strong balance sheet?
Firstly, you need to demonstrate that your business can meet its financial obligations. If you think about this logically, you need to demonstrate that there is enough cash or income generating assets in the business to pay its bills. A company that has more debt or liabilities than its assets, is generally considered to have a weak balance sheet.
Liquidity is also important. One ratio you can use is dividing your current assets, for example, sales, with your liabilities, or costs. This is called the current ratio.
Another ratio you can use is subtracting any inventory you may have if you are a product based business from your current assets and then dividing this by your current liabilities. If your answer is 1 or higher, that means your business is in a strong financial position. This is called the quick ratio.
You can also use ratios to keep track of debt in your business. The cash-to-debt ratio is calculated by adding the cash and short term investments the business has and dividing this by the current and long term liabilities. If the outcome is equal to or higher than 1.5, you are managing your debts well in the business, another sign of your business’ financial strength.
You need to keep an eye on your balance sheet over a period of time, as it is a snapshot in time, usually created and reviewed on an annual basis when completing your financial reporting to HMRC and/or Companies House.
It is a good idea to review your balance sheet in the context of historic years to find trends that work in your favour. For example, you may start your business with a weak balance sheet as you invest heavily and/or grow your brand and profit, but as your business establishes and scales, you can demonstrate a strengthening balance sheet over time.
Is my balance sheet weak?
You can spot a weak balance sheet by considering the factors mentioned above and applying the ratios.
Generally speaking, if a business shows little to no retained earnings or profit in the business in a twelve month financial period, this could be viewed as a weak balance sheet, although there may be a good reason. For example, as note above, you are in the early stages of building your business and not yet established.
Showing a weak balance sheet over several 12 month financial periods will be of concern, and should be addressed as early as possible.
Your strong balance sheet checklist
If you start to focus on a strengthening balance sheet you are building a business fit for the future, a business that can operate efficiently, create profit and support the future goals of the business.
Your checklist for a strong balance sheet will tick the following boxes:
A strong current ratio: having enough cash to meet day-to-day cash flow demands in the business to make a profit
A good debt-to-equity ratio: if your business has debts, such as an overdraft, a credit card, loans, you can demonstrate that you are managing these debts well in your business and that it is not impacting your liquidity or profitability.
More debtors than creditors: Your debtors list, people who owe you money, is more than your creditors list, the people you owe money to. Your clients or customers pay you on time so you can meet your overheads and bills in the business.
A positive net asset position: You have a ‘positive’ net worth if your assets, or the assets that your business owns, are more than the liabilities of the business.
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What are assets?
Assets include cash, stock inventory, and payments due to you from sales (receivables). Cash is usually the most important asset in the business.
What are liabilities?
Liabilities include long-term debt, loans, for example, and any customer deposits for services to be delivered at some point in the future.
What is Equity?
In simple terms, when you see mention of equity on the balance sheet, this refers to the owner’s equity in the business, in other words, the value that an owner of a business has left over after liabilities are taken into account.
