Balance Sheet Basics

Is your company always able to pay debts promptly?

If your answer is yes, you’re doing a great job! Most businesses have cash flow headaches now and then and many have constant cash flow problems. And what’s more, often businesses don’t know where they stand financially or what to expect in terms of cash flow.

The profits of a company do not always reflect how much cash is on hand for daily operations. Ensuring that all contracts include great profit margins does not ensure that your cash flow will be smooth.

Smart business owners use the Balance Sheet as one of the tools to determine their company’s financial health at a specific point in time. Also used in conjunction with the Balance Sheet is the Profit & Loss Statement, but we’ll discuss that at another time. The Balance Sheet is comprised of:

  1. Assets – what the company owns
  2. Liabilities – what the company owes
  3. Owner’s Equity – book value of the business
It is important to note that the Assets must always equal Liabilities plus Owner’s Equity; it must balance out. In addition, having greater total current assets than total current liabilities does not necessarily mean you have enough to meet monthly bills. Within the above three categories, look for two key items:

  1. Cash in Bank (this is the most important item on the Balance Sheet)
  2. Total Current Liabilities
Compare the totals of these two and you can see in an instant just where you stand in terms of survival. Cash is the fuel that keeps the business running.

A key accounting formula contained in the Balance Sheet measures working capital. Normally, if you show positive working capital it probably means you have enough to cover current liabilities that are coming due. However, this may not always be the case. The formula below is used to figure out how much working capital a business has:

Total Current Assets minus Total Current Liabilities equals Working Capital.

Note that Current Assets may include Accounts Receivable and Inventory. The totals for these may be large, but this still doesn’t mean your cash flow is healthy, or that you’ll meet payroll and bills this month.

  • Accounts Receivable often includes invoices that may not be paid for 45 or even 60 days (or more) from your customers. It is monies you have not yet collected. If this number represents more than three months’ worth of sales, it could become a problem.
  • Inventory refers to goods for sale, which is not cash on hand. You have to determine if you have too much inventory; or, on the other hand, do you run out often, creating potential lost sales?
Maybe you have considered requesting Cash on Delivery (COD) for all your products and services so you can keep control of cash flow. But this will limit your market severely. In today’s world customers would rather hold onto their cash for as long as they can.

One method of establishing predictable and consistent cash flow is to focus on the outstanding accounts receivable. The accounts receivable or invoices of a company can be sold at a discount to a factoring underwriter, for immediate cash. Many business owners are not yet aware of this great tool for enhancing a company’s cash flow.

Every business – whether start-up or seasoned – will experience a cash flow crunch at some point, if not many times. Success in a business is far more readily achieved – and it’s a lot easier to keep the lights on – when you have a dependable flow of cash on hand.

Below is a sample Balance Sheet. You’ll note that the Cash in Bank does not meet Current Liabilities in this instance. Compare this with your own company Balance Sheet to get a feel for the different indicators.

I hope this post de-mystifies a bit of the financial process for you and your business, and helps you set a path to healthy growth. It’s not always easy to grasp this stuff, though, so please feel free to contact me for more information.

Continuing this series about Stress-Free Ways to Manage Your Small Business Cash Flow, I’ll return to the subject of Small Business Finances 101 now and then. If there are areas you would especially like me to address, please say so in the comments.