Each month you should compare your current Balance Sheet to the prior month and to the prior year the same month. How does the current Balance Sheet compare? Hopefully you have less debt this month than you did last month or last year. Did you add new assets? If so, how have those assets contributed to your revenue (you’ll have to analyze the Income Statement to answer this question)?

So what information does the Balance Sheet provide? Here are a few of my favorite Balance Sheet ratios with a description of the knowledge gained from the results:

1. Current Ratio. Determined by taking your current assets divided by current liabilities. You want a ratio of at least 1:1 or better. This ratio measures your ability to convert your current (short term) assets into cash to pay your current (short term) debt. Generally, a ratio of 1:1 isn’t going to give you enough cash to pay your debts so you want to strive for a 2:1 or better.

2. Receivables Turnover ratio. Compare your net credit sales to your accounts receivables by taking Net Credit Sales divided by Average Net Receivables. The result will give you the number of times per year you collect your accounts receivables. For example, if the result of the formula is 6 then you are collecting your receivables about once every 60 days.

3. Average Collection Period. Convert your Receivables Turnover ratio into days outstanding by taking 365 and dividing by the Receivables Turnover ratio result. Assume your Receivables Turnover was 12; we would then get 30.4 days your receivables are outstanding (ratio: 365/12).

4. Debt to Total Assets ratio. If you needed to convert your assets into cash to pay your long-term debts, would you have enough to cover your outstanding balances? The Debt to Assets ratio will tell you. To determine the proportion of debts to assets take your Total Liabilities divided by Total Assets.

Perform an analysis on your Balance Sheet for the current month. Then do the same for the prior month and the same month the prior year. What do the trends look like? What information have you gained from this analysis?

For a small business the Balance Sheet may not change much from month to month. However, checking the balances weekly or monthly for accounts receivable and accounts payable is a good practice. Determine how much of your accounts receivable balance is over 30 days old. What can you do to get your customers to pay within the next 10 days? Do you have any outstanding balances to your vendors that exceed 30 days? If so, will they be willing to continue to do business with you until the balance is paid?

The Balance Sheet can give you a snapshot of the overall business health. Do you own more in assets than you have in debt? If not, then you should consider what tactical, i.e., short term, actions you can take to reverse this trend. Are you liquid enough that you could pay your short-term debts, if necessary? What about your long-term solvency? Will you be able to service the long-term debt sitting on your books? Or should you contact your bank to negotiate a lower interest rate or extended payback period?

The information on the Balance Sheet is fairly logical and intuitive, which is probably why it gets overlooked as a financial tool for internal users. Consider how a banker might view the information on your Balance Sheet. Would you be willing to loan money to you? Do some analysis on the Balance Sheet to answer that question and then make a list of five things you can do to improve your company’s financial position.

There are several advantages and disadvantages to debt financing and maintaining an appropriate debt-to-equity ratio is essential for securing future financing as well as for long term financial health. Financial experts cite numerous advantages to Debt Financing. One of the main advantages is that debt financing provides funding without diluting the ownership of the company. Additionally, with debt financing, lenders do not have a claim on any future profits of the company; the lender is limited to receiving an amount equal to the loan principal plus interest.  Most business owners find that raising capital from debt financing is much easier than equity financing as business owners do not have to comply with state and federal securities regulations. Debt financing also provides tax benefits in that the interest paid to service the debt is tax deductible.

Companies often find that there are disadvantages to debt financing. One of the obvious disadvantages is that funds financed through debt must eventually be paid back. In debt financing the principal and interest payments become fixed costs that must be accounted for when a company is determining its break-even point. Although debt payments occur on a fixed schedule, the payments require careful budgeting of cash flow which can be difficult for new businesses or business with highly varying business cycles. Debt financing also negatively affects the company’s debt-to-equity ratio causing lenders to view the company has a higher risk. With debt financing there is generally a requirement to offer company or personal assets as collateral to secure the loan. Small business owners often have to personally guarantee the loan, in full or in part. A personal guarantee means that if the company cannot pay back the debt the owner pledging the personal guarantee will repay the loan with his personal funds.

The decision to borrow funds from a bank or find an equity investor can be a tricky one. With debt you are only obligated to pay back the principle plus and interest component. With an equity investor you give up a portion of ownership in your company and your payment of dividends/distributions are variable over the life of their investment. An analysis to determine which option is best for your company should be completed before making a lending decision.

Unlike the purchase of supplies the purchase of a large asset, such as a car, is “capitalized”. What this means is that you don’t recognize the full cost of the car as an immediate expense. Instead, you report the value of the car on the Balance Sheet as an asset. You should have a corresponding debt for the car in the liabilities section of the Balance Sheet, unless you paid cash for it. Then you determine the life of the asset, cars are generally considered to have a useful life of 5 years for depreciation purposes. As such, the cost of the car would be allocated to the income statement for each of the next 5 years. We’ll ignore the Balance Sheet aspects for now.

Depreciation is what we commonly refer to as a “non-cash” expense. Continuing with the car example, if we pay for the car with cash our cash outflow is in the first year, yet we allocate the cost of the car over 5 years. Which means that the profitability of your company is going to be impacted by the depreciation even if you no longer have any car payments because the payment of the asset and the allocation of depreciation expense do not take place simultaneously.

Depreciation allows you to better match the useful life of the asset with the revenue you are generating due to the benefits produced by that asset. If you were to expense the entire value of the asset in the year of purchase your profits in that year would be unnecessarily low and future years too high.

There are many ways to measure the profitability of your company. Income taxes are calculated based on net income, including all non-cash expenses. Whereas you can also look at cash basis profitability which would only include items that actually increase or reduce cash. Sometimes business owners like to see a line item on their income statement that is commonly called EBITDA (earnings before interest, taxes, depreciation and amortization). Another approach that I use for my clients is EBDA (earnings before depreciation and amortization) so that they can compare their net profits with non-cash expenses included to their net profits based mainly on cash only items. Figure out what works for you and use that as a measure to determine your monthly, quarterly and yearly goals.

Let’s take a closer look at this. Net worth is a combination of money invested by the business owner and an accumulation of profits over the life of the business. In general, net worth can be described as the overall difference between what a company owns versus what it owes.

Sometimes a company may need an influx of money in order to buy new equipment, purchase a new building or develop a new product. Or perhaps they need money for advertising. Whatever the reason, the owner can either put more of his own personal money into the business, which increases his equity in the business, borrow funds from a bank, or seek an outside investor. If a company has reached its borrowing capacity they may need to add a partner/shareholder rather than seeking money from a bank.

The net worth of a business should increase each year. This assumes that the business is generating positive net income (i.e., sales are greater than your expenses). Even if your net income is increasing each year, your net worth could be decreasing. There are a few reasons for possible decreases, such as the owner taking distributions out of the business or an increase in debt (which can decrease net worth as a percentage, not dollar amount). But the important thing for any business owner to keep in mind is, a positive net worth does not a guarantee success, but a negative net worth could be reasons to assess your business and make immediate changes.

Current Liabilities are generally monies owed to employees or suppliers. In addition, you should record reserves for taxes and short term loans, when applicable. 

Why is the classification of Current Liabilities important? In order to extract a true picture of the company’s ability to pay the debts you need to consider what is due now and what is due later. While your long-term debt require payments on a on-going basis, you have more flexibility to renegotiate the terms on long-term loans than you do on short-term items.

Comparing your Current Assets to your Current Liabilities will let you know how much liquid cash you may have if, for some reason, you needed to pay your short-term debt today. Formula note: divide Current Assets by the Current Liabilities to get the Current Ratio result; this result should be greater than 1 to 1. If your Current Ratio result is too low, you might not be able to pay your short-term obligations.

To determine the amount by which your Current Assets exceed your Current Liabilities subtract these two amounts to determine your Working Capital. Working Capital is basically your operating liquidity, i.e., the amount available to satisfy short-term obligations and upcoming operational expenses.

When you compare trends of the Current Ratio and Working Capital for your company over time you will get a sense of how well, or poorly, you are managing your short-term debt. Whether or not you want to, you must become comfortable with reading your company’s balance sheet in order to make good business decisions. Otherwise, ugly words like debt may become unmanageable.

Current assets are defined as the items that will be used by the business or converted into cash within a 12 month period, generally the calendar or fiscal year. Assets include items such as Cash (or cash equivalents), Inventory, Accounts Receivable, Prepaid Expenses, and Marketable Securities.

Two accounts to track on a regular basis are Accounts Receivable and Inventory. How quickly you collect payments your customer owes you will depend, in part, on the industry you are operating within. For most businesses, you should be collecting payment in full from your customers at least every 30 days. Failure to collect money on a timely basis will tie-up this much needed cash, which could lead to cash flow problems. Use the Receivables Turnover Over ratio to determine how often you “turn” your collections each year. Convert that information into the Average Collection Period to get the number of days your Accounts Receivable are outstanding.

It is important to monitor the balance in your inventory account too. Too much inventory will tie-up cash unnecessarily. Yet too little inventory will cause you to miss out on possible sales. Use the Inventory Turnover ratio to determine how often you are “turning” your inventory per year. Again, you can convert this information into the number of days inventory sits on the shelf.

The saying “Cash is King,” has merit, but if you don’t use the Balance Sheet as a tool to figure out where your cash is going or where it is tied up, you’ll never have enough cash to run your business effectively. While a Balance Sheet does not give you the entire picture, the current assets section of the Balance Sheet can be a great starting point to assess how you are doing and what you need to do next.