By Jennifer Barnes, CEO of Optima Office, a firm that provides Fractional CFOs, COOs, Controllers and HR professionals for businesses.
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Some business owners are tempted to leave their balance sheets to their accountants, but it is important for leadership to understand how to read their balance sheets in order to keep an eye on their finances. Many businesses don’t realize their companies are facing financial difficulties or are on the verge of being insolvent until it is too late. If your company is in financial danger, meaning your liabilities are much greater than your assets, there are some strategic moves that can help you turn things around.
The balance sheet provides value as it illustrates how well capitalized a company is. It reflects the value of a company’s liabilities, or debts, and the value of the company’s assets. This information reflects how financially healthy the company is and is therefore critical for investing and operating decisions. The balance sheet also shows the accumulation of the company’s profits and losses. (This is expressed as equity on the balance sheet. Total Assets – Total Liabilities = Total Equity.)
The balance sheet is a snapshot at a moment in time of how much your company is worth. The accounts on your balance sheet are categorized as either assets, liabilities or equity. Those three categories together make up the balance sheet, the purpose of which is to provide the reader with a view of the financial condition of the company at a given reporting date.
However, it is also important to pay attention to trends. Looking at your balance sheet at just one point in time doesn’t necessarily give you anything to compare it to. Have you improved or declined over time? What is the trend occurring with your balance sheet? Which accounts are increasing and which are decreasing? In a perfect world, your assets are increasing, your equity is increasing (thus your net worth is increasing) and your liabilities are decreasing. (One very important thing to note is that each account on your balance sheet must move every single month unless it is a deposit, retained earnings or an interest-only principal loan account.)
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An important ratio to focus on within the balance sheet is your “current ratio.” The ratio is calculated by dividing your current assets by your current liabilities. Anything over 1.25 is considered healthy. The goal is to own more than you owe! Anything under 1 is considered insolvent, meaning your liabilities are greater than your assets. You can increase sales, decrease expenses, get investors to add capital into your business or find ways to reduce liabilities over time to solve for this. Understanding what moves your balance sheet accounts and what each account means is imperative to understanding the health of your business.
As a reflection of a company’s financial health, businesses use the balance sheet to gauge their ability to maintain operations, meet their financial obligations and make investments for growth. The stronger the balance sheet, the more confidence a business owner will have in maintaining itself as a going concern and making decisions and investments to drive profits and expansion.
Investors, on the other hand, use a balance sheet to gauge the level of risk they believe there is in investing their money into a company. Again, the stronger the balance sheet, the more confidence an investor will have. If you are thinking of selling your business — or even just curious as to the value of the company — understanding your balance sheet can help reveal the value. Or, if you want to apply for a business loan, the balance sheet can help the bank approve your application and determine how much they should lend you.
In summary, all three financial statements (the income statement, cash flow statement and balance sheet) are required to get the most complete picture of a company’s health and performance. Knowing how to read and understand your financials is imperative to running a successful business long term.
