Financial statements can be a bit of a mystery to the uninitiated. If you begin to glaze over when it comes to looking through your balance sheet, you’re not alone.
We are often asked, “What’s the balance sheet for and what does it really mean?” It often comes as a shock that the balance sheet can make or break a business.
The profit and loss statement is probably easier to understand, in that it simply shows the income at the top, costs and overheads below and the difference is your profit or loss. Profit and loss is usually reported monthly and for the year to date. The figures are usually based on invoices in and out (i.e. not just cash transactions). This means when an invoice is raised, it is accounted for in the profit and loss, even though payment may not have been received. This is referred to as ‘accrual accounting’.
The balance sheet lists the balance of what the business ‘owns’ and what it ‘owes’ at a given point in time – usually the end of the month. It’s a bit like a personal financial position (e.g. you own your home, motor vehicle and furniture and you owe the mortgage, vehicle loan and credit cards). The difference between what you own and what you owe is your personal equity in your belongings.
Some examples of what a business owns:
- Cash in the bank – positive bank balance or cash deposits
- Amounts owed by customers (debtors or accounts receivables)
- Stock – finished goods and raw materials assets
- Work in progress or costs on jobs not yet invoiced
- Assets, such as vehicles, equipment, furniture and fittings
- Deposits paid, such as rental bonds
Some examples of what a business owes:
- Bank overdraft – negative bank balance
- Amounts owed to suppliers (creditors or accounts payables)
- Outstanding lease amounts liabilities
- Taxes due (e.g. GST and PAYG)
- Staff superannuation amounts due
- Unused staff leave
The above lists are not exhaustive, but are an example of typical assets (what you own) and liabilities (what you owe). As described in the personal financial situation, the difference between what the business owns and what it owes is referred to as equity. In the equity section of the balance sheet is also shown the balance of previous and current year profits and losses carried forward. Simply, it’s where the ‘wash up’ of the profit and loss statement sits and how the two reports link together.
The important issue to understand is that if you only look at the profit and loss statement, you are only seeing half the picture about what is going on in the business.
The following are key issues affecting business performance as reflected in the balance sheet:
Amounts owed by customers (debtors or accounts receivables)
If this area isn’t being constantly managed it can cause cashflow to dry up. An example is one of our clients who recently assumed a very large organisation was just slow as always to pay, but the truth was the purchase order and invoice didn’t match up, which causes malfunction in a bureaucratic organisation and the amounts were not paid and no explanation was given to the client. These invoices totalled $160,000, which is a hefty portion of the client’s cashflow.
Amounts owed to suppliers (creditors or accounts payables)
An over-efficient accounts payable person can be the worst enemy of cashflow in a business, and wasting available credit is ruinous to cashflow.
Excess stock very often becomes dead stock. Bulk purchase discounts can seem attractive, but if the goods are going to sit around and become obsolete, it’s a false economy.
Work in progress (jobs not yet invoiced)
The longer jobs aren’t invoiced, the longer the money isn’t in the bank. The longer a job isn’t invoiced, the greater the likelihood of a dispute when an invoice is raised. Regular invoicing not only helps cashflow, it also means that people remember what went on when a contractor was working, for example.
Bank reconciliations are a vital way of checking that everything is correct in the bank account. Is everything that is coming out of the bank correct? Are there any deposits that have gone astray? Are there deductions made incorrectly, such as leases ended where amounts are still being withdrawn. We saw an example of this recently where one of the major banks deducted five extra months lease payments on a lease that had ended.
Unused staff leave
Letting staff hang onto leave can cost money and is often more expensive to pay out than the rate at which it was accrued (i.e. when they accrued the leave they were on a lower rate of pay than when it gets paid out).
GST and PAYG can be a real slug if you haven’t factored them into your cashflow. The business may be profitable, but if it hasn’t collected payment from customers it might be paying GST on uncollected funds.
The danger of being under-capitalised and then trying to grow the business by big sales quickly is what brings many businesses undone. We saw a business go under recently – it took on a big project at the same time as spending working capital on websites, office fit-out, a fancy workshop, etc. Unfortunately, we didn’t get to them before they had passed the point of no return.
The acid test – Your Quick Asset Ratio
The ‘Quick Asset Ratio’ is a measure of how well a business can meet its short-term obligations. The ratio is calculated as follows:
(Cash + Accounts Receivables + Other Current Assets) / (Overdraft + Accounts Payables + Other Current Liabilities)
Example of Quick Asset Ratio calculation:
A business has the following
Cash in the bank $60,000
Accounts Receivables $80,000
Other Current Assets $30,000
Accounts Payables $60,000
Other Current Liabilities $40,000
Calculation ($60,000 + $80,000 + 30,000) / ($60,000 + $40,000) = 1.7
The Quick Asset Ratio for this business is 1.7. That means the business has $1.70 of short-term resources for every $1.00 of short-term debt.
Banks look very closely at ratios to determine business health and lending risk. Banks vary and change their view on desirable ratios, but a ‘Quick Asset Ratio’ of 1.7 would be considered acceptable.
A business may show a profit, but if the balance sheet doesn’t look healthy, cashflow squeeze can be the result and make it very difficult to run and grow the business.
Maximisation of what the business owns and minimisation of what it owes is the key to business financial health.
Sue Hirst is a director of CAD Partners, a nation-wide mobile CFO “On-Call”/financial control/business accounting service for SME owners.
Photo: Martin Kingsley