Whether you’re looking for financing or an investment in your company, one thing is certain – your balance sheet matters. Find out why having a strong one is crucial, and how to strengthen your balance sheet to weather a downturn in the market.
A statement of financial position
At any given time, your balance sheet offers a snapshot of your overall financial picture. It accounts for your assets (cash, accounts receivable, inventory, investments and equipment), your liabilities (accounts payable, credit cards, loans, mortgages, vehicle financing, income tax and employee salaries) and shareholders’ equity. A balance sheet shows what you own and what you owe.
This is how the balance sheet actually balances, and your shareholders’ equity is the result of your assets minus your liabilities.
Assets - liabilities = Shareholders’ equity
Having a strong balance sheet is about more than just numbers – it means having a healthy foundation for your business, which is important in both good times and bad. An ideal balance sheet has more current assets than current liabilities, healthy receivables and a good debt-to-equity ratio (more on this later).
Your balance sheet is sometimes known as a statement of financial position, because it tells potential lenders, investors and buyers how solvent your business is. Being solvent means that you’re able to pay your bills when they are due.
So, how solvent is your business?
To reveal how solvent your business is, you can look at a few ratios. The first divides your assets by your liabilities, the second focuses on your cash (as opposed to your inventory).
This calculation is quick and simple: Use the Current assets and Current liabilities listed on your balance sheet to see your asset-to-liability ratio. For example, you may have $2 in cash and accounts receivable for every $1 of accounts payable, tax owing and credit card debt you owe. This is also known as liquidity, which helps explain the business’s ability to pay its near-term financial obligations.
Current Assets divided by Current liabilities = Current ratio
If you had to liquidate all of your assets tomorrow, would you be able to pay down all your debts? How much would you have left over?
Debt coverage ratio
Enter the debt coverage ratio. This figures out if you have enough quick money, or ready cash, to pay bills if your creditors needed payment immediately.
(Current assets - inventory) divided by Current liabilities = Debt coverage ratio
To do this calculation, subtract your inventory or stock from your assets figure. Then divide this number by your liabilities. You’ll never want this ratio to dip below 1:1.
How much financing has your company had? Each time you get a loan, this increases your total liabilities. Shareholders’ equity is the amount of funds investors have placed in the business, plus all historical company earnings.
Liabilities divided by Shareholders’ equity = Debt-to-equity ratio
If this ratio is high, it shows that your company has borrowed a lot of money, and is not yet making more than you are borrowing.
How can you boost your balance sheet?
Evaluating and improving your business’s balance sheet has many benefits. You can optimize your cash flow and get a clear picture of your finances. It’ll also helps you figure out if you should take on debt or investors.
Here are a few ways to make your balance sheet stronger:
- Shift your inventory. If you have slow-moving inventory, you might want to sell it, or bundle it with more popular items to help move it. If you decide to write off this inventory, make sure to choose the right time of the year to do so.
The faster that you can turn over your stock, the more efficient your business and inventory management will be.
- Improve your debt-to-equity ratio. You can achieve this by bringing in more sales, or unloading assets such as office equipment or real estate. Besides improving your cash flow, boosting this ratio will put you in a better position to grow and raise capital.
- Cut the cash going out. How can you reduce your overhead on everyday operations? Strategies may include looking for new vendors, scaling back on non-necessities, streamlining marketing or outsourcing business tasks.
- Set up your emergency cash reserve. One trick is to put one-third of your cash on hold to use in the case of an emergency (or to take advantage of unexpected opportunities).
- Manage your accounts receivable. Unpaid bills put pressure on your cash flow. Focus on managing your accounts receivable to ensure you are paid. For example, are you tracking your sales invoices in Excel vs proper accounting software? Learn the accounting software we use at True North to manage it all.
How to make a balance sheet
- What is the year-end date?
- What assets do you have?
- What are your liabilities?
- Calculate your shareholders’ equity.
- Add total liabilities to shareholders’ equity.
- Compare this number to your assets.
A note for sole proprietors
Most sole proprietors don’t really need a balance sheet, since there is no separation between the person and the business. Check out our step-by-step guide to bookkeeping for sole proprietors.
How to calculate retained earnings
Retained earnings track all the equity accumulated in your company from day one. It’s the number that reflects everything your business has been through.
Note: This is a book value using accounting figures, and might not resemble the value of your business.
Retained earnings are the profit you have left over after paying your direct and indirect costs, taxes and shareholder dividends. This number is calculated in your business’s income statement and appears in the shareholders’ equity section of your balance sheet.
You may decide to reinvest your retained earnings back into your business. Small businesses often use retained earnings for working capital, to pay for new equipment, research and development, or marketing.
Get the numbers relevant to your business
A balance sheet offers important insights into your business, so depending on your needs, you may want to create one yearly, quarterly, or even monthly. (We can help with that!)
At True North Accounting, we help small business owners set up a foundation for success and thrive. Book a meeting with one of our knowledgeable CPAs so we can look at the numbers, give you the low-down on how your business is doing, and create a plan for growth.
Need a refresher on small business accounting terms? Find other Bookkeeping topics that may be helpful to you and your small business.