I don’t understand what’s going on, on the balance sheet.
Thoughts of the Day: The balance sheet takes a snapshot of the health of the company at a specific point in time. Most business owners concentrate on learning how to use the Profit and Loss Statement, but overlook how the Balance Sheet can help them. The balance sheet helps to set goals for how you, as a business owner, want things to change over time.
There are three parts to the balance sheet: assets, liabilities, and equity. Assets are broken into two or three major categories. Current assets are items that are already in cash, such as a checking account, and items that can be converted to cash within 12 months, such as accounts receivable.
Liabilities represent the debts of the company. Like assets, short term liabilities are liabilities you expect to pay off within 12 months. This includes credit lines and the current year’s portion of any term loans. Long term liabilities are debts that are expected to take more than a year to pay off.
Multi year term loans and multi year equipment loans are 2 examples of long term loans. With long term loans, ideally the amount of principal to be paid off during the year is moved from long term liabilities to current liabilities. Each month, as you make payments on your loans, part of that payment goes to reduce principal. This shows up on the balance sheet as a reduction in the current portion of the long term loan. This is a little bit of extra accounting paperwork, but gives the business owner a much more accurate picture of what’s happening to liabilities throughout the year.
Equity is what is left over when liabilities are deducted from assets. The equity section of the Balance Sheet is the sum of several items, including shares issued in exchange for investments made in the business, goodwill, and retained earnings among others.
Goodwill is meant to represent intangible values, for example the value of proprietary systems and brand equity. Setting its value is tricky, complicated and requires outside expertise.
Retained earnings represents the sum of all the net income that has been re-invested all the years. It doesn’t have to be cash. It can show up as cash, inventory, fixed assets, property, etc. Business owners have a choice to make at the end of each year. They can remove net income from the business and take it home, or they can leave net income in the business and use it to boost retained earnings and equity.
One of the ways to measure progress in a business is to monitor ratios. Debt to Equity and Current Assets to Current Liabilities are 2 keys ratios to keep on top of. A good rule of thumb is to keep Debt to Equity ratio below 250%, meaning that for every dollar of equity, the company has no more than $2.50 of loans and other debts.
A good rule of thumb for Current Assets to Current Liabilities ratio is to keep above 200%. In other words, for every dollar owed, that must be paid off in the next 12 months, the company has $2 or more dollars in current assets. Companies with high inventory and concerns about how quickly they can sell it off, may want to deduct inventory from current assets when calculating the Current Assets to Current Liabilities ratio. This is known as the Quick Ratio.
Planning to sell the business one day? Accurately attending to the balance sheet throughout the years of business, and focusing on building up assets and reducing liabilities leads to more options. Ability to leverage the company and staying on top of having enough cash through the years to build a healthy company helps you build long term exit value. Retaining earnings in the company, rather than taking everything home each year puts you in control of how the company grows and helps you to build sale value according to a plan.
Looking for a good book? How to Read a Balance Sheet: The Bottom Line on What You Need to Know about Cash Flow, Assets, Debt, Equity, Profit…and How It all Comes Together, by Rick Makoujy.