Understanding the Balance Sheet
Reading the Balance Sheet should be easy and a vital part of the healthy feedback loop
The Balance Sheet provides information about an organization's financial position at a particular point in time. This statement shows how the organization's assets, liabilities, and equity relate. The balance sheet equation is Assets = Liabilities + Equity.
When reading the Balance Sheet, the Methodology and Accuracy are much easier to see within the Financial Statement. Unfortunately, many small business owners don't pay enough attention to their balance sheet. When we at realCFO start to review your financials, it is the first thing we will look at. It tells us if the business is healthy by comparing assets and liabilities. We seek a healthy balance sheet where the company can weather difficult times.
The Balance Sheet tells what resources it has to run the business. Current assets, such as Inventory and AR, should be easily converted into cash. Assets like land or offices take more work to convert into cash. Current liabilities are going to consume cash quickly, such as AP. Other liabilities like notes payable will consume cash over the long term.
We will continue to look at Steve’s one-person company; he is a life coach.
Refer to the Substack on the P&L.
Details are as follows:
Assets:
Cash - is currently in the bank or the sum of every cash transaction from the business’s inception.
Accounts Receivable (AR) - is only the Speaking Engagements for which he gives 30-day terms. And is included in working capital.
Inventory – Merchandise typically sold at speaking engagements. And is included in working capital.
Fixed Assets – computer and A/V gear that has been 50% depreciated.
Accounts Payable (AP) – miscellaneous expenses. And is included in the working capital.
Accrued Expenses – expenses that Steve knows about but has not received an invoice for, such as a new desk in April.
Notes Payable – is the computer and A/V gear in Fixed Assets.
Equity – is the total investment amount and gains or losses from the business’s inception, which we will cover later.
When we read the Balance Sheet, we look at a few standard key performance indicators (KPIs).
Looking at Steve’s working capital, the Working Capital Ratio* (current asset/current liabilities) is entirely out of whack, at 2,362.2% in April. Seeing such a curious KPI, realCFO will start to dig into the detail. In general, an established organization would see something under 25.0%. It is easy to see a number north of $5,000 of inventory in Steve's current assets, with minimal current liabilities.
Steve has over nine and a half years of inventory. This is an issue from many financial standpoints. Will the inventory still be good in nine years? Does Steve know where all the inventory is? These are but a few questions that need to be asked. After we talked to Steve, he agreed to a physical inventory of his merchandise. He confirmed he had all but $1,500 in merchandise he gave his one-on-one clients in February. He also confirmed he was buying at higher quantities to get the discount to increase his profits.
We need to coach Steve on two issues regarding his business: understanding anything on the Balance Sheet should be reconciled at least quarterly, and buying too many assets ties up cash.
realCFO will coach Steve on building a process that ensures the bookkeeper gets the information needed to reconcile Inventory; coordination is critical.
realCFO will challenge the notion that a volume discount does not increase profit. Steve should only buy what he can sell for one or two months, depending on the lead time (the time it takes for the merchandise to be delivered). Steve has 114 months of merchandise tying up cash. realCFO recommends a fire sale to turn inventory into cash. Which will help restore the balance sheet to a healthy position.
Reading a balance sheet does take some time to learn. What will speed up the process is understanding what each balance represents. AR is work you have done but have yet to receive payment. Inventory is something physical you are going to sell. Fixed assets are tools used to run the business. AP & Accrued Expenses are bills not paid. Notes Payable is a long-term loan. It also will help to account for everything on the balance sheet accurately. Most small business operators know these numbers intuitively, making the balance sheet a critical piece of the feedback loop.
What is your balance sheet telling you?
I look forward to helping you; let me know what you think in the comments below, or for a more personalized review, schedule an appointment with me here.