The Owner’s Calendar – 8 Things You Need to Know About Your Balance Sheet

Most owners keep a close watch on their monthly profit and loss statements, knowing that revenues must exceed expenses in order to have a viable business over the long-term and to build their own personal net worth.

Too many owners, however, fail to keep an eye on their balance sheet and therefore miss the opportunity to notice important trends that will impact their cash flows and the overall financial condition of the business. Business history books are full of examples of profitable companies that failed because they did not understand all the ingredients of their cash flow streams. Most of these ingredients are found on the balance sheet and not on the profit and loss statement.

The balance sheet is a snap-shot of a company’s financial condition on a particular date, usually at the end of the month or year.

Balance Sheet Categories

Assets are everything the company owns. Assets are divided into two groups:

  • Current – assets that are expected to be converted into cash within one year. Typically, these include cash, accounts receivable, and inventory.
  • Non-current assets that are permanent or have useful lives longer than one year. These include land, buildings, equipment, IT infrastructure, and vehicles. Non-current assets also may include the purchase price or development cost of intellectual property or the goodwill of a business purchased in an acquisition.

Liabilities are the debts the company owes and are also divided into two groups:

  • Current – liabilities which must be paid within one year. Current liabilities typically include accounts payable to vendors, compensation owed to employees, and loan payments due to banks or others within one year.
  • Non-current – liabilities, including loan payments, due more than one year from the date of the balance sheet.

Net Worth is also known as Owner’s Equity and represents the book value of the company. It is equal to Assets minus Liabilities and consists of four primary balances:

  • Owner’s investment – the amount (usually cash) the owner has invested in the business
  • Retained earnings – the cumulative amount of profits and losses earned by the business in prior years
  • Current earnings – the current year’s profit or loss of the business
  • Distributions or Dividends – the cumulative amount of profits paid out to the owners of the business

Getting to Know Your Balance Sheet

With an understanding of the basic framework of a balance sheet, let’s begin to unpack how this statement can help decipher and predict what is happening to the cash flows in our business. Understand that your balance sheet is very specific to your business model. While there are some overall guidelines discussed below, it is important that you understand the composition of the various account balances on your balance sheet and watch the trends in those balances as you experience different business cycles.

Here are 8 key accounts to get to know on your balance sheet:

  • Accounts Receivable – represents the amount owed to you by your customers. Generally, if you extend 30 day payment terms to your customers and you invoice them at the end of the month, you would expect the balance of this account to be approximately equal to the current month’s revenues. If the balance is growing, it is either because your revenues are growing or your customers are not paying. If it is the latter, you should find out why immediately and take corrective action (for more information about improving your collections through internal processes, read “Customers Not Paying? Check Inside Your Own Organization First”).
  • Inventories – represents the raw materials, work in process, and finished goods owned by the company at the balance sheet date. Managing inventory is one of the most challenging aspects of running a business. As the owner, do not put inventory management on autopilot. There is a natural tension between the operational goals of having enough goods on hand to meet production and customer needs, versus the financial impact of investing in either too much or the wrong inventory. Set up systems to check in on inventory by knowing quantities on hand, what inventory is selling, and what parts are piling up in the warehouse. Usually it is better to take action on slow-moving inventory as quickly as possible and move on to other issues, rather than to do nothing and hope that sales of a once hot product will rebound.
  • Capital Assets – these are described on the balance sheet in various ways depending on the business but include Property, Plant and Equipment, Furniture and Fixtures, and Property. In a services business, the capital asset accounts may have relatively small balances. However, most manufacturing businesses are capital intensive, meaning there is significant investment in facilities, equipment, and control systems. A capital intensive business should have an investment plan that forecasts the cash needed over the next three to five years to purchase new equipment for expansion or improvements in efficiency, and to replace outdated equipment and systems.
  • Accounts Payable – represents the amount you owe to vendors who have extended credit to you. These amounts have already been recognized as an expense on your profit and loss statement, but they have not been paid yet so you must ensure there is enough cash on hand or coming from customers to pay them. Generally, vendors require you to pay in thirty days, although it may be appropriate to negotiate longer terms in certain industries. There is a correlation between accounts receivable and accounts payable on your cash flows. You can partially mitigate the impact of extending payment terms to your customers by negotiating similar or longer payment terms with vendors (or conversely by negotiating shorter terms with your customers, such as 20 days). Stretching vendor payments beyond the stated terms is an alternative as well, but it should be a short-term strategy as it could damage a critical vendor relationships.
  • Compensation Payable – this balance might be stated on the balance sheet as accrued payroll, accrued bonuses, commissions payable, or something similar, and represents amounts owed to employees for their services. Like vendor invoices above, these amounts have been reflected in your expenses but they have not yet been paid. It’s important to monitor these balances to ensure there are plans in place to accumulate and set aside the necessary cash to pay these liabilities.
  • Accrued Expenses – these are typically estimated expenses that were appropriate to record in your profit and loss statement prior to the balance sheet date, but you do not yet have an invoice for the expenditures and they have not yet been paid. An example might be the settlement of a dispute with a vendor or customer in which you know you are going to pay something, but the final amount has not been determined. It is important to understand the composition of these items so that you can plan for the eventual cash outlay.
  • Current Portion of Long-term Debt – as noted above, the payments due on loans from banks or other lenders is broken into a current portion representing payments due in the next twelve months and a non-current portion representing the balance due beyond one year. This presentation is specifically designed to allow you to monitor and plan for the cash required to meet your loan commitments over the coming year.
  • Owner’s Equity – there are four basic ways to fund the cash needs of a business: loans from banks or other financial institutions, trade credit provided by vendors, investments from the owner, and profits from prior periods. The balance in Owner’s Equity represents the last two forms of financing and contains the owner’s cumulative cash invested in the business, less any dividends or distributions, plus the profits retained in the business. There is no hard and fast rule as to the appropriate balance in owner’s equity, but know that commercial banks expect the owner to have “skin in the game”, meaning that the owner should maintain a meaningful amount of equity in the business. A good rule of thumb would be that the liabilities of the company are not more than 3 times the amount of owner’s equity. For more information about owner’s equity read “The 5 C’s of Credit.”

Getting to know and understand your balance sheet will take time, but it is a worthwhile investment in helping you plan your financial success.