When it comes to entrepreneurs, most are at least vaguely familiar with their Income Statement, otherwise referred to as P&L (Profit and Loss). But you are certainly not alone if you just don't get the Balance Sheet. Many entrepreneurs simply ignore it. It's a shame really, because the Balance Sheet is a beautifully succinct communication tool that says so much about your business. Next time you are looking at your financials, don't just gloss over your Balance Sheet. Instead, have a good look at it. The Balance Sheet is organized as a snapshot of your business at a particular date and when compared against a prior period can be an indicator of positive or negative trends. Go grab your Balance Sheet and let me help you get a little more familiar with it.
1. Cash - This one is pretty easy and right at the top of your Balance Sheet. Everyone knows what cash is right? Cash is King! Cash is the lifeline of business. It is precious and when sparse causes great business inefficiency, dysfunction, not to mention STRESS! Now, give cash a bit more thought and ask yourself if your business has enough? I have worked with enough CEOs to know that you don't tend to adjudicate your cash position logically, but I have not yet been able to conclude why! In order to logically answer the sufficiency question you need to consider what your cash needs are. A ratio called "Days of Cash On-Hand" will help you adjudicate your cash position and determine how many days you could get through if you did not make another sale. A simple way to calculate this is to total your operating expenses (making sure not to include depreciation) and devide it by the number of days in the period. This gives you your cash operating expenses per day. Divide this number by the amount of cash showing on your balance sheet and that will essentially tell you how many days you could continue to pay your expenses for without interuption. Now - ask yourself that question again - do you have enough cash?
2. Accounts Receivable - From the point at which you invoice a client until you receive payment, you will have a balance showing as Accounts Receivable. Banks consider accounts receivable to be a liquid asset because it can be converted into cash within a short period of time. However banks do not consider A/R to be liquid if they sit too long. Receivables that are older than 90 days are often dismissed by banks due to their increased risk of not being collected. Your homework is to generate (or ask your bookkeeper for) an 'Aging Receivables Report' so you can stay on top of those outstanding receivables.
Tip: Current Assets are presented on the balance sheet in order of liquidity.
3. Total Current Assets - In addition to cash and receivables, your balance sheet categorizes anything else that will be used up (or converted into cash) within one year as a Current Asset. The importance of whether you have enough Current Assets is relative to what your Current Liabilities are, so skim to your Current Liabilities and compare the two. The Current Ratio divides Current Assets by Current Liabilities to determine if you have enough resources to pay your debts over the next year. This ratio is also known as "liquidity ratio" or "cash ratio". The higher the better, and ideally the banks want to see a Current Ratio of 2:1 and some say a ratio of less than 1:1 infers insolvency. Do the math and note your current position. Put a stake in the ground and give some thought on how to improve it.
Okay - that's enough for today.
Have any questions? Ask away.