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.
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.
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?
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.
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:
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.
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.
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.