Why the Balance Sheet Matters
Richard Pittelkow – Most of our ISBDC clients understand the Income Statement and how revenues must exceed expenses to have a viable and valuable company. However, many people tend to overlook the Balance Sheet and do not have a basic understanding of its composition and importance. Balance Sheets do matter, and a business owner who does not pay attention might have a rude surprise when he or she runs out of cash or applies to the bank for renewal of loans. One of the many advantages of utilizing an accounting software program (i.e., QuickBooks or Peachtree) is that the Balance Sheet is calculated automatically without any ongoing input required from the business owner.
A Balance Sheet summarizes a company’s Assets, Liabilities and Owners’ Equity (Net Worth) at a specific point in time, usually at the end of an accounting period. The purpose of a Balance Sheet is to give users an idea of the company’s financial condition along with displaying what the company owns and owes. It helps business owners quickly get a handle on the financial strength and capabilities of their business. Balance Sheets, along with Income Statements, are also the most basic elements in providing financial reporting to potential lenders such as banks, investors, and vendors who are considering how much credit to grant to companies.
Explanation of General Balance Sheet Categories
- Assets: Everything of value that the company owns
- Current Assets – Can be converted into cash within one year – Cash, Receivables, Inventory, etc.
- Fixed Assets – Permanent in nature – Land, Buildings, Machinery, Equipment, etc.
- Other Assets – Intangibles such as Patents and Goodwill
- Total Assets – Total of all above Assets
- Liabilities: All the debts that the company owes
- Current Liabilities – Debts due within one year from date of Balance Sheet – Payables, Loans etc.
- Long Term Liabilities – Debts due more than one year from date of Balance Sheet – Loans, etc.
- Total Liabilities – Total of all above Liabilities
- Net Worth: Assets minus Liabilities – book value of the company
- Owner’s Equity Investment – Owner’s investment (cash & equipment) in the company
- Retained Earnings – Prior years’ Net Profits/(Net Losses) “retained” in the business
- Net Profit – Current year’s Net Profits (or Net Loss)
- Total Net Worth – Total of all above Net Worth accounts (Total Owner’s Equity)
- Total Liabilities and Net Worth – Adds to the same amount as Total Assets; therefore Assets are in “balance” with the total of Liabilities and Net Worth.
Sample Balance Sheet
|Total Current Assets||$95,000|
|Buildings – Net of Depreciation||$95,000|
|Equipment – Net of Depreciation||$70,000|
|Total Fixed Assets||$165,000|
|Accounts Payable||$ 4,000|
|Short Term Loans Payable – Bank||$45,000|
|Total Current Liabilities||$49,000|
|Long Term Liabilities:|
|Long Term Notes Payable – Bank||$85,000|
|Total Long Term Liabilities||$175,000|
|Owner’s Equity Investment||$20,000|
|Net Profit||$ 7,000|
|Total Net Worth||$37,000|
|Total Liabilities and Net Worth||$261,000|
There are many ways to analyze the financial health of a business utilizing the Balance Sheet. One of the most important is the calculation of days of Working Capital – [(Current Assets minus Current Liabilities) divided by (Total Annual Expenses divided by 365)]. Utilizing the above Sample Balance Sheet and assuming $150,000 in annual expenses, the days of working capital would be 111.9 [(95,000-49000) / (150,000/312)]. This calculates how easily the company can handle the normal ups and downs of revenues while still paying its bills. Eventually, every business will have a month, a quarter, or a year when cash-out exceeds cash-in and without a cushion, the company risks going out of business when this occurs even if vendors, creditors, and employees know the set back is only temporary. In addition, the lack of sufficient Working Capital can be evidence of mismanagement to lenders and investors. Companies should have at least 30 days of Working Capital, and financially strong companies will have 180 days or more.
Three or more years of Balance Sheets can be analyzed for other identifying trends. Is the receivables cycle lengthening? Can receivables be collected more aggressively? Is some debt uncollectable? Has the business been slowing down payables to forestall an inevitable cash shortage? Are Net Profits being retained in the business for future growth or being withdrawn by the owners? Is exhausted equipment being regularly replaced? Are the debts of the company trending up or down?
I encourage all business owners to learn more about the Balance Sheet and review it at least quarterly in order to identify trends and make informed financial decisions. Your lender is reviewing it regularly and basing your company’s creditworthiness on it, and business owners should be doing the same.
Richard Pittelkow is a Business Advisor for the West Central Indiana Small Business Development Center, an organization with the mission of having a positive and measurable impact on the formation, growth, and sustainability of small businesses in Indiana, and to develop a strong entrepreneurial community. Richard can be reached at email@example.com.