For a business owner, a set of Financial Statements can be an important tool in running your business. Generally speaking, there are three sets of statements that are commonly prepared by accountants. The Balance Sheet, Income Statement (Statement of Income and Retained Earnings), and the Statement of Cash Flows. In this blog post we’ll go into a bit of detail as to what information each statement can provide. By understanding these statements, you’ll have a better understanding as to the areas in your business that you are excelling at and other areas that may require more of your attention. It will also help you gain a better understanding of what other people are seeing in your business too. This is especially important when you are looking to get financing from a bank or other financial lender.
What is the Balance Sheet?
The Balance Sheet is prepared for a specific date in time. Generally, the statement is prepared at the end of a fiscal period or year-end. The purpose of the statement is to provide a snapshot of a business on a particular date. It gives an overview of a company’s Assets (Cash, Inventory, Accounts Receivable, Fixed Assets), Liabilities (Accounts Payable, Bank Loans, Shareholder Loans) and Equity (Share capital, Retained Earnings/Deficit).
Key Line Items on a Balance Sheet
Some key areas of the Balance Sheet that business owners should review regularly are Cash, Accounts Receivable, Inventory and Accounts Payable.
Cash is king/queen. It is what is going to pay for everything that you do in your business. Without it, you will need to invest more into your company or you will need to look to external parties to invest or loan you funds to give you time to make your business profitable. Monthly reconciliations of the bank balances allow you to ensure that you know how much money you have in your bank account that can be used to pay your suppliers and employees. If you have a retail business and receive payment for purchases through a credit card processor, you can use the bank reconciliations to ensure that the payments from the credit card company are being deposited on a frequent basis and that the deposits match to what you think that they should be. Reconciliations also give you and your accountant comfort that you have captured all of the transactions in the period in your accounting records. Without it, you may be able to cherry pick which transactions are recorded in your business and you may not get a true picture of your cash position.
Accounts Receivable should be reviewed to ensure that your customers are paying you on time. If you find that you have had a record-breaking quarter in revenues, but your bank account is low, it’s likely that you have not received payment from your customers. You should be in touch with them on a
regular basis to ensure that they can still pay what they owe you. If there is an account that is not collectible, consider writing it off or at least providing a provision that it won’t be collected. If your provisions are increasing month over month, you may want to see if your pricing is appropriate or if your target markets need to shift to customers who are more likely to pay the full amount and on time.
Inventory is another area that should also be reviewed on a frequent basis. If you have inventory, you should review to ensure that what you have in inventory, is still saleable. Is anything damaged or obsolete? Have you performed a count of all your inventory to ensure that what you think should be in available for sale is actually available? By keeping an eye on your inventory and continually checking to make sure that you have enough goods on hand and that they are saleable, will limit the possibility of theft occurring and that damaged goods or unsaleable products are identified early enough so that you can either dispose of these goods or sell them at a discount to make room for more saleable options.
Accounts Payable is the other key number on the Balance Sheet that should be reviewed regularly. This allows you to monitor what bills need to be paid in the next 30 days and what can be deferred to a later date.
Balance Sheet Financial Ratios
You will often hear in conversations amongst business owners terms like Current Ratio and Inventory Turnover. So what are these ratios and what do they tell you about a business?
The current ratio determines if a business has enough funds available to pay off their operating expenses or current obligation. To calculate this amount, you would take your current assets (or items that are cash or can be quickly converted into cash, such as Cash, Accounts Receivable and Inventory) and compare this amount to the company’s current liabilities (Accounts Payable, Taxes Payable and Current portion of Debt payable) to see if the current assets are greater than the current liabilities. If the Current Assets are greater than the Current Liabilities, the lenders will gain confidence that the business can pay off their operating expenses.
Example: On December 31st, for the current assets, Cash is $5,000, Accounts Receivable is $10,000 and Inventory is $20,000. For the current liabilities, Accounts Payable is $20,000, GST Payable is $5,000, and the current portion of the debt payable is $25,000. Therefore, the current assets total to $35,000 and the current liabilities total to $50,000 and the current ratio computes to 0.70. The business owner and potential lender should start being concerned that they may not be able to pay their suppliers on a timely basis since they do not appear to have enough liquid assets available to pay their liabilities.
As a point of reference, a good target ratio is about 1.0. Most external parties will be looking for this regardless of the industry.
The inventory turnover ratio will inform a business owner or potential lender how quickly the inventory is being sold. To calculate this ratio, you would take the Cost of Goods Sold and divide it by the Average Inventory Balance. To calculate the average inventory balance, you would take the inventory balance at the beginning the period plus the inventory balance at the end of the year and divide it by 2.
Example: On January 1st, the inventory balance is $100,000. During the year the company recognized $200,000 in Cost of Goods Sold. On December 31st, the inventory balance is $75,000. The Inventory Turnover ratio is therefore $200,000 divided by ($100,000 plus $75,000 divided by 2) = 200,000/((100,000 + 75,000)/2) which equals 2.29.
The inventory has turned over more than 2 times during the year. This business owner should be confident that the risk of having obsolete inventory is low. However, this doesn’t eliminate the need to review the inventory on hand to make sure that there isn’t any old inventory still held by the company.
Another area that a lender will look at is how much money the business owners have invested into the business. This can be viewed by looking at the Liabilities and Equity sections of the balance sheet. If there is a large shareholder loan in the liabilities section of the balance sheet, this is an indicator of how much money the Shareholders of the company have invested into the company. If the Shareholder Loan is located in the Assets section of the balance sheet, this is an indicator that the Shareholders have withdrawn money out of the company and owe it back to the company. Lenders will often prefer to see a Shareholder Loan balance located in the Liabilities section of the balance sheet, which indicates that a Shareholder has some stake in the business and an interest in reinvesting and growing the business rather than removing all of the wealth from the company.