Balance sheets are the unsung heroes of our industry’s accounting management tools. Love ‘em or hate ‘em, they’re vital to your business, and learning to read them correctly will supply you with information that can keep your company out of financial trouble, as well as show you some important growth opportunities. Let’s take a quick look at the fundamental ways that your balance sheet will help you better manage your company.
Before we dive in, allow me to dispel the common misperception that the income statement is more important than the balance sheet. While the income statement typically gets, by far, the most attention from owners, accountants, and managers, it does not take precedence over the balance sheet. Income statements are easy to understand and, generally, we have a little more control over it. The income statement allows us to see whether we’re winning or losing in the short term, so it’s easy to prioritize it over the balance sheet.
The balance sheet, on the other hand, will reveal the long-term health of your company. It tells you if you’re structured properly or if you might be at risk of default — whether you have too much debt or if you could take on more to grow.
Unfortunately, when I’ve asked to review a client’s income statement and balance sheet in the past, I’ve often been told that the company doesn’t know how to pull a balance sheet. I’ve also been told that they aren’t going to send a balance sheet because “they don’t have any part in that — the accountant takes care of it,” which, in my experience, is far from reality. At the end of the year, the accountant will usually make a couple entries and call it done, without really reviewing the information.
Even if you have an external accountant who is responsible for closing your financials, you need to ensure that they are also reconciling your balance sheet. Ask them about items on the balance if they don’t look right to confirm they are reviewing it and verifying the accuracy of the accounts.
Once you’ve solved the problem of who’s responsible for generating the balance sheet, commit to reviewing it every month. Typically, you won’t be reviewing it with the same eye for detail as your profit and loss (P&L) statement, but you do need to make sure all the information is accurate. If you’re an owner, ask your accountant about any accounts that don’t look quite right: What’s in those accounts and how is the information populated? If you’re an accountant, review information in each account and, at the end of each month, confirm balances and the transactions that comprise them. If line items or sub-totals need to be moved off the balance sheet and onto the P&L, make those entries, so all your information is correct.
Once you’ve confirmed that all the information is accurate, you’ll want to examine a few key ratios. The first is the “current ratio,” which is the calculation of your current assets divided by current liabilities. This ratio measures your company’s liquidity, or your ability to pay your short-term obligations. A current asset is an item that you could expect to convert to cash within 12 months, and a current liability is an expense you expect to pay within 12 months. If your current ratio is under 1:1, you might be in trouble.
The second ratio to explore is a variation of the current ratio: the “quick ratio,” which is your current assets minus any prepaids or inventory, divided by current liabilities. The quick ratio is also a measure of your company’s liquid cash position, but it’s more of a true measure of liquidity, as it removes items in prepaids and inventory that probably can’t be converted to cash quickly.
Finally, the third ratio to review is the “debt-to-equity ratio,” which is your total liabilities divided by equity. This ratio shows how you’re leveraging debt in your company. A high ratio here will tell you that your company is leveraged and has a high amount of debt compared to equity. A very low number here might be a good thing, meaning you don’t have much debt. A very low ratio could also tell you that there are growth opportunities if you utilize more debt to grow the company.
There are many more ratios you can calculate from the balance sheet to give you even more information about your company’s overall health. However, if you start with these three fundamentals, you’re well on your way to making your balance sheet work for the long-term success of your company.
Publication date: 4/15/2019