Ah, the balance sheet. The keeper of small business financial insight—if only it didn't read like a complete foreign language to you. For most small business owners, reading a balance sheet makes day-to-day accounting feel like a piece of cake. But the balance sheet is important. This article will help you learn how to read a balance sheet so that you can make better business decisions based on data, not just hunches.
What is a Balance Sheet?
A balance sheet is a piece of your financial statements. It is a snapshot of your company’s assets (what you own), liabilities (what you owe) and equity at a particular point in time. A critical component of a balance sheet is that we are not looking at a balance sheet through a range of dates, but on a specific date. Cloud accounting software like Kashoo gives you access to the balance sheet whenever, wherever. And that's a good thing because it's important to take a look at your balance sheet on a regular basis.
Knowing how to read your balance sheet is important for several reasons. It can tell you how liquid your business is. It can also tell you how solvent the business is. The balance sheet can point to certain trends and show certain levels of risk. Moreover, your accountant can extract all sorts of additional insights from it. That said, there are a few simple balance sheet analysis techniques that can help you get a better understanding of your business’ position at a given point in time.
Compare Your Numbers
If you’ve been in business for several years, a balance sheet will show your current year’s numbers in one column as well as the previous year’s numbers in another column. It’s always a good idea to compare these numbers as they can tell you certain things. For instance, if you noticed that your Accounts Receivable balance has doubled from last year to this year, that could be amazing news because you might remember that your sales have actually doubled from the prior year, so keep up the good work! But if your sales haven’t doubled while your accounts receivable has, then investigation is required. Why? Because it might indicate that you have not collected on your accounts receivable fast enough, or even worse, it could indicate bad debts.
Comparing your cash balance is always something to look out for as well, as cash is your company’s lifeline. Without it, your company can’t survive. Personally, I always look at each and every balance sheet line and compare the numbers to the prior year just to make sure everything is in line. If something looks out of line, then investigate. Hopefully your accountant is ahead of you on this and is already doing the investigating on your behalf.
It’s all about Liquidity
Liquidity is how capable your business is to pay off its upcoming or immediate liabilities for the coming year (ie. your current liabilities). If you cannot pay off these liabilities with your assets, then you will have a problem continuing the business. A quick way to determine if you are liquid is to compare your current assets to your current liabilities. To determine which assets are current, consider which assets can be easily converted to cash within 12 months. Obviously cash is a current asset. Accounts receivable are also usually considered current assets as standard collection terms are 30 days. So if you have $100,000 in current assets and $30,000 in liabilities due within the upcoming 12 months, we can assume that the business is fairly liquid and will have no issues paying off these obligations.
Liquidity is essential for the future operation of your business, so keep an eye on it.
You should also identify your current assets and current liabilities in order to determine whether your business is liquid or not. If not, don’t panic! Talk to your accountant before you do anything, there are always solutions.
Long-term Debt and Solvency
You may have had a spectacular idea for a new mobile app or a web-based business, but in order to get that idea to market, you had to take out a sizable loan. Loans of this nature are normally paid out over a period of time that is longer than one year and are therefore considered long-term on the balance sheet. Assessing your ability to pay your long term debt obligations on time is critical for any business and indicates solvency. We won’t get into anything too technical here, but essentially, we want to compare our equity on our balance sheet (ie. the owner’s net worth in the company) versus the amount of long-term debt outstanding on the balance sheet. Generally, the higher this ratio is, the more solvent your business is.
Your Balance Sheet and You
There are many technical ways to examine your balance sheet, but what’s important for the majority of small business owners is that they have some comfort over their business’ balance sheet. You can leave the fancy stuff to your accountants, but at the end of the day, it is your business, so take control!
Ryan Lazanis, CPA, CA, and Kashoo MVP, is the owner and founder Xen Accounting, a fully virtual, online Chartered Accountant firm in Canada geared specifically for micro businesses, consultants and freelancers. Designed for modern day business owners who are constantly connected and always on the move, Xen Accounting uses innovative new technologies to make accounting more convenient and less painful.