Many small businesses reliably produce a set of financial statements each year, listing assets and liabilities, revenue and expenses, cash flow and shareholder equity. Often, outsourced bookkeeping services prepare these reports, but the documents are quickly forgotten by business leaders as they focus on the day-to-day challenges of running the company — particularly since these documents are rarely required for tax preparation and other small-business reporting.
However, setting this data aside is a grave error that can cripple small businesses. Successful companies keep their financial statements front and centre, creating their short and long-term strategic plans with an eye on current and future balance sheet figures.
Insight Into Financial Health
Balance sheets are primarily used to gain understanding and insight into a company’s financial health. These statements detail the company’s assets, liabilities and shareholder equity, offering a holistic perspective on overall financial position — specifically, what is owned versus what is owed.
This view differs from the information offered on income statements significantly, in that an income statement appears as a snapshot in time. It shows revenue that has been earned and expenses that have been paid, but there is no visibility into what is owed. Over-reliance on the income statement can lead to disastrous spending strategies, ultimately crippling cash flow.
For example, after a large sale, revenue figures are robust. However, supplier invoices have not yet been addressed. The resulting impression is that the business is in a strong financial position. What the income statement doesn’t show is the large amount due to suppliers in upcoming weeks. If managers rely on income statements to make large financial decisions, they can find the business is short when bills come due.
Income statements provide a helpful view into transactions that have already occurred, but balance sheets give a clear picture of overall financial standing. This offers an opportunity to identify potential issues early so that business planning is tailored appropriately.
Detailed View of Financial Standing
Frequently updating balance sheets keeps a company’s net worth front and centre. This figure is critical in assessing the health of a business, both for managers and investors. In addition, over time, a comparison of balance sheet data illustrates the effectiveness of business leaders.
For example, a comparison of accounts payable and accounts receivable data across balance sheets for an extended period demonstrates business habits with regards to collecting payment from customers, as well as ability and reliability in paying creditors as agreed. Issues in either area can point to a serious problem.
Another frequently discussed item is the level of inventory noted on the balance sheet — specifically, the ratio of inventory to other assets. When inventory is permitted to dominate the assets column, small businesses run into significant issues. Examples include additional expenses for storing, maintaining and insuring inventory, as well as the likelihood of losses if the items become obsolete.
Too little inventory comes with its own set of problems. Long delays in fulfilling customer requests lead to lost revenue. Careful monitoring of inventory levels over time gives small-business owners the opportunity to optimize this asset.
Balance sheets offer early warnings for other potential issues. These include inadequate cash reserves, which can lead to cash flow issues. Low cash also indicates the company is unable to invest in growing the business.
Forecasting Future Needs
Investors gamble when they put money into a business. They are predicting that the company will be profitable in the future, giving them a return on their initial investment. However, smart investors don’t risk their funds blindly. Through study of financial statements, including the balance sheet, they are able to make reasonably accurate predictions about what the future holds for a particular organization.
The most successful business leaders use these same techniques to understand upcoming risks and opportunities for the company. Often, they use proven formulas to derive meaning from the information on balance sheets. Some of the most useful financial ratios include the following:
- Current Ratio = Current Assets ÷ Current Liabilities: The current ratio shows whether the business has enough cash on hand to pay bills coming due in the near future. Most business leaders try to keep this ratio at 1.5 or higher.
- Debt-to-Equity Ratio = Total Liabilities ÷ Shareholders’ Equity: The debt-to-equity ratio compares how much the business investors own versus how much is owed to creditors outside the business. In other words, the debt-to-equity ratio illustrates the extent to which the business relies on debt to operate. Ideally, this ratio is as low as possible.
- Working Capital = Current Assets – Current Liabilities: While a positive working capital figure is desirable in some industries, others prefer to see negative working capital on this line. Regardless of which applies to your small business, the balance sheet permits you to monitor the situation, making corrections as needed.
Businesses that lack the time, expertise or both to regularly update financial statements don’t have to miss out on the benefits. Outsourced bookkeeping services offer a simple, cost-effective way to refresh balance sheet data for maximum visibility into the company’s financial position.
Can your business be more financially healthy? Look no further than Skytrax Accounting and Payroll Services and schedule a consultation today.