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.

First compare the prior month and same month the prior year by looking at the gross dollar amounts. You can gain some basic information about how your business is doing. While the dollar figures provide some information as to what areas to focus on in the future, it is helpful to convert some of this information into percentages to get a more accurate picture. For example, let’s assume that your Gross Revenues decreased slightly from May to June. It should follow that your Cost of Goods Sold decrease too. Assume that in May the Gross Margin was 60% but in June it was only 55%. What happened? Did your vendors increase their costs? Or did you sell your products at a discount in order to generate more sales? What is the trend in the Gross Margin over 6 months? Over 3 years?

There are many other ratios you can use to evaluate your business using the Income Statement. Since every business is different there is not one ratio that is necessarily more important than the others. Two of my favorites are:

1. Receivables Turnover (Net Credit Sales/Average Net Receivables) – provides the number of times per year that you are collecting your outstanding Accounts Receivables. You can convert this into days using the following formula: (365/Receivables Turnover ratio)=days.*

2. Profit Margin ratio (Net Income/Net Sales) – provides the rate of the conversion of sales into profits.

It is important to monitor the balance of cash in your checking account. However, a review and ratio analysis of the Income Statement will help determine how effective you and your business have been generating and using cash.

*Note, the Receivables Turnover ratio includes an item, average Net Receivables, from the Balance Sheet.

The higher the current ratio of the company, the better equipped they are at paying their vendors and any short term loans. If their current ratio is low it signifies to a bank, lender or vendor that the company has a lot of debt, but not necessarily that the company is going bankrupt. As there are many different ways to access financing so a low current ratio does not mean that a company will be unable to pay back their loans if they suddenly become due.

Current ratio is very similar to acid-test ratio, however, acid-test ratio does not include inventory. The acid-test ratio is much more focused on the ability to pay debt immediately with liquid cash or cash equivalents. The result of the acid-test ratio is the amount of liquid assets, that if sold, a company could use to pay its short-term debt on short notice.

So, what do you do with this information? That depends on why you are measuring your financial data. Maybe you are approaching a vendor for credit terms with their company. They may want to see your acid-test and current ratio results. If you are seeking a loan from a bank they will most definitely want to know the results of these two ratios. Maybe you are considering a marketing campaign or creating a new product line. Do you have enough cash or cash equivalents to be able to fund these efforts? Or you are operating on a very tight cash budget? If so, these ratios will give you a picture of where you stand at any given point in time.

Keep in mind that every company and business is unique and operates differently than another, so you need to locate the industry average that is most applicable to your business for a comparison point. If you can locate the ratio results of your competitors that is even better information. Even so, how you use this information is more important than how you compare to others in your same line of business.

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.

But, ratios can help you identify trends early allowing you time to take corrective action. There are many places on the web to find explanations on how to calculate ratios as well as explanations as to what they mean. A few of my favorite liquidity (short-term) ratios are:

1. Current Ratio (calculated as current assets divided by current liabilities) – this ratio will tell you what your current asset ratio is to your current liabilities. If you needed to pay a vendor or bank quickly, you will need to have liquid assets that you can convert to cash.

2. Receivables Turnover (calculated as Net Credit Sales divided by Average Gross Receivables) – Net Credit Sales are those sales that are made on credit, not credit cards, but the credit your company extends to clients. Average Gross Receivables is the average of the last two years of Gross Receivables. This ratio tells you how many times per year you are collecting your outstanding accounts receivable. The higher the number the better. To convert this into days take the result from the Receivables Turnover and divide by 365 days.

3. Inventory Turnover (calculated as Cost of Goods Sold divided by Average Inventory) – This ratio, like the Receivables Turnover ratio, will tell you how many times per year your inventory turns. Again, the higher the number the better. To convert this into the number of days your inventory is sitting on the shelf take the result and divide by 365 days.

The benefits of ratios cannot be overstated. Just reading your financial statements each month is a good start, but will not give you all of the information you need to make quick changes to your business.