As a business owner, there is so much to keep your eye on; watching your sales, tracking your expenses, reviewing bank account balance, trying to get money in, grow your business .. the list is endless. While time can be precious it is important to take a step back once a month for a financial review.
Taking the time to stop and look at the big picture is a chance for you to evaluate your business.
Are things working as you expected? Should you make changes to your strategy?
A key part of your financial review is to help you answer these questions and take a look at your balance sheet; conducting a balance sheet analysis.
This is probably one of the most frequent and most important questions that a business owner asks themselves. Knowing what you have in the bank is the key to most financial decisions. You find this in the asset section of your balance sheet under “current asset”.
Keeping track of how much money you are owed is also an important part of your financial position. You’ll find this number in the accounts receivable row on your balance sheet.
As your sales increase, this number is likely to increase, too. If some customers aren’t paying you as quickly as you would like, you’ll see this number grow. For most businesses, figuring out how they can convert accounts receivable into cash is an ongoing challenge.
If you sell products, you deal with inventory. While your balance sheet doesn’t tell you exactly what products you have on hand and how many of each, it does tell you the value of that inventory.
Keep in mind that the value of the inventory listed on your balance sheet is what you paid for that inventory, not what it might be worth if you sold it to customers.
Inventory is a current asset because the assumption is that you can convert that inventory into cash relatively quickly.
If you have other assets, both other current assets and what are called “long-term assets,” you’ll also find those listed on the balance sheet. Long-term assets are things that you would typically hold for a longer period of time and are more difficult to convert into cash.
If you own the building that your business is in, for example, that would be a long-term asset.
In terms of a monthly financial review, you’re probably less likely to need to keep close track of this number. It’s not likely to change significantly unless you are investing a lot of money into new buildings and large equipment.
Just like you’ll want to keep a close eye on who owes you money, you’ll also want to track how much money you owe to your suppliers. Like most businesses, you probably don’t pay bills the day they come in. Those accumulating bills will show up on the accounts payable line of your balance sheet.
How much cash you have in the bank and how much your customers owe you will likely be factors as you consider how quickly you want to pay those bills.
In addition to bills from your suppliers, your business is probably accumulating other debts. Those are called “current liabilities” and will show up on your balance sheet in that section.
Examples of these other debts are things like sales VAT that you’re collecting from your customers and need to pay to the HMRC, income taxes, and other loans that you may have.
A great way to do a balance sheet analysis is to monitor key ratios that will give you a quick snapshot of your business’s financial health. While there are many ratios you can review for your business, there are two in particular that relate to the balance sheet and will give you important insights into your business.
The current ratio measures your business’s ability to pay back its debts—it’s short-term liabilities in balance sheet jargon. You calculate the ratio by dividing current assets by current liabilities:
Current Ratio = Current Assets / Current Liabilities
You want this ratio to be above 1. If the ratio falls below 1, it’s a warning sign that your business may not be able to pay its debts when they become due. This isn’t always bad news — it just signals that you should look into how your business is running. In some industries, it’s perfectly normal for businesses to carry a lot of debt, which will make the current ratio low.
The quick ratio is a variant of the current ratio. Unlike the current ratio that looks at all of your business’s current assets and assumes you can use them to pay bills, the quick ratio only looks at the cash your business has on hand plus accounts receivable (money that your customers owe you).
Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities
Like the current ratio, you want this number to be higher than 1, and the higher the number, the better.
BALANCE SHEET REVIEWS SHOULD BE QUICK AND EASY
It probably took you longer to read this than it will take you to review your balance sheet on a monthly basis.
It may seem complex at first, but with a little practice and an understanding of what the numbers mean and what they tell you about your business, you’ll be able to read a balance sheet in a couple of minutes. Magic!