Why does a balance sheet matter?Many small businesses routinely look at their income statement and cash flow statement, but most don’t realize the importance of the balance sheet. The balance sheet is an essential financial statement that all companies should review regularly, as it fluctuates with every transaction.As an example, let’s look at Reliable Plumbing, a commercial plumbing company that generates $12 million in annual sales. As the owner of Reliable Plumbing, Joe’s balance sheet is an important aspect of his business, but managing a growing company requires a lot of Joe’s time. His gut tells him that unless he spends more time analyzing his financial results, he’s going to make some poor business decisions.Joe’s current method of financial analysis is pretty basic. At the end of each month, he generates an income statement and takes a look at his net income or profit. He also scans other financial responsibilities like tangible and intangible assets, shareholders equity, total liabilities, total assets, and long-term debt.Joe divides net income by sales to calculate the company’s profit margin. Profit margin reports the amount of profit earned on each dollar of sales. His analysis gives him a sense of each month’s level of profit.After reviewing profitability, Joe takes a look at his cash balance by generating a balance sheet. To get an accurate look at cash, he reconciles the bank account and compares the cash balance to his average cash balances for the past 12 months.If the cash balance seems low, he checks accounts receivable to see if any large receivable balances are outstanding.Joe doesn’t perform any other analysis. Unfortunately, without further scrutiny into his balance sheet, Joe isn’t able to monitor his overall financial health at any given time. Just by taking a little time to delve into his balance sheet, Joe could solve many problems long before they damage his business — making this one of the best ways that Joe could use his time.
Return on time investedJoe’s limited review is typical for many business owners that only view profitability and available cash as the most important metrics to track. However, all business owners need to understand the components of the balance sheet, and how the balance sheet is connected to the income statement and the cash flow statement.If Joe is willing to invest the time and use a balance sheet template, he can make more informed business decisions and achieve a better financial position for his company.
The components of a balance sheetA balance sheet is important because it provides business owners with a snapshot of what they own, the balances they owe, and how much their business is worth.While profit and cash are necessary, other pieces of financial information are just as important. When you start to use a balance sheet template to track your finances, you are better able to find hidden costs, reduce expenses, and maximize profits.
How is a balance sheet related to an income statement and cash flow statement?As a business owner, it’s important to understand the connection between a balance sheet, income statement, and cash flow statement.First, consider how the income statement and the balance sheet work together in Joe’s business. Reliable Plumbing earned a 15% profit margin on $12 million in sales or $1.8 million in net income. Net income from the income statement increases the owner’s equity balance in the balance sheet. When Joe prints his month-end balance sheet, the $4,500,000 equity balance includes the month’s $1.8 million in profit.The cash balance on the balance sheet is the ending balance in the statement of cash flows. The cash flow statement essentially takes the company checkbook and assigns cash inflows and outflows into these categories:
- Cash activity from financing: A company raises money to operate the business and pays it back. Issuing common stock is a cash inflow and repaying a loan is a cash outflow.
- Cash activity from investing: Investing refers to buying and selling a company’s assets. If Reliable pays cash for a truck, that’s a cash outflow, and if the company sells some equipment for cash, that’s a cash inflow.
- Cash activity from operations: Every cash transaction that is not related to financing or investing is posted here. This includes activities like paying employees and collecting money from customers.
Using financial analysis to increase cash flowFor many business owners, the most important metric for their business or their statement of financial position is the amount of cash they need to operate each month. This may be more important than profit since no company can operate without sufficient cash.Think about it this way: If Reliable Plumbing generates a 15% profit on every dollar sold, then 85% of every dollar sold is an expense. When the monthly sales equal $12 million, Reliable incurs $10.2 million in expenses. Those expenses have to be paid in cash, either this month or sometime down the road.A business can generate more cash by reducing the balance in two accounts that tie up cash:
- Accounts receivable
- Inventory balance