Every business owner has a finite amount of time, and successful managers use their available time to achieve better outcomes. Understanding the balance sheet can help you make more informed decisions for your business. If you can analyze how the balance sheet connects to other financial statements, you can increase your cash inflows and profitability. Use these tips to get a clear understanding of the balance sheet.
Why Is a Balance Sheet So Important?
Joe owns Reliable Plumbing, a residential and commercial plumbing company that generates $12 million in annual sales. Joe’s business is well established and his firm has a great reputation in the community, but managing a growing company is requiring more 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. Joe divides net income by sales to calculate the company’s profit margin. Reliable Plumbing typically operates at a 15% profit margin, which means that the firm generates 15 cents of profit for every dollar in sales. Joe computes the profit margin each month and compares the result to his average profit margin for the year. His quick analysis gives him a sense of each month’s level of profit.
After reviewing profitability, Joe takes a look at the cash balance by generating a balance sheet. To get an accurate look at cash, he reconciles the bank account and compares the reconciled 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 need to be collected quickly.
Once he checks profit for the month and reviews his cash balance, Joe doesn’t perform any other analysis.
Return on Time Invested
Joe’s quick review is typical for many business owners, because they view profitability and available cash as the most important metrics to track. After all, there are a dozen fires that need to be put out to run the business—why spend any more time on what happened last month? It’s a fair question.
All business owners, however, 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, he can make more informed business decisions and get better company results.
The Components of a Balance Sheet
A balance sheet is important because it provides the owner a snapshot of what they own, the balances they owe and how much their business is worth. Using the balance sheet requires an owner to change their thinking. Profit and cash are important, but there are other pieces of financial information that are just as important.
Here are the three components of the balance sheet:
Assets: Just about anything you use to make money in the business is an asset, and many assets are posted to the balance sheet. Reliable Plumbing owns plumbing trucks, equipment and a warehouse, just to name a few assets. Assets are what the business owns.
|Current Period||Prior Period||Increase (Decrease)|
|05/01/15 to 05/01/16||05/01/14 to 05/01/15||05/01/15 to 05/01/16|
|Cash||$ 21,506.00||$ 20,000.00||$ 1,506.00|
|Total Current Assets||48,804.00||47,300.00||1,504.00|
|Furniture and Equipment||28,777.00||30,777.00||(2,000.00)|
|Less: Accumulated Depreciation||(43,183.00)||(45,201.00)||2,018.00|
|Total Fixed Assets||233,537.00||233,519.00||18.00|
|Total Other Assets||6,254.00||6,271.00||(17.00)|
|TOTAL ASSETS||$ 288,595.00||$ 287,090.00||$ 1,505.00|
Liabilities: This section of the balance sheet lists bills that are owed and long-term debts. Liabilities include salaries owed, utility bills due and any loans payable to a bank. Liabilities are what the business owes.
|Business Credit Cards||7,523.00||6,000.00||1,523.00|
|Sales Tax Payable||1,055.00||1,000.00||55.00|
|Current Portion of Long-Term Debt||12,111.00||12,111.00||-|
|Total Current Liabilities||42,249.00||40,611.00||1,638.00|
|Less: Current portion of Long-term debt||(1,200.00)||(1,200.00)||-|
|Total Long-Term Liabilities||197,217.00||193,332.00||3,885.00|
Equity: Assets less liabilities equals the equity balance. Reliable Plumbing, for example, has $7.2 million in assets and liabilities totaling $2.7 million. Assume that Joe sells all of his assets for cash, and then uses that pile of cash to pay off every liability. Any money that remains is the firm’s equity. Reliable’s equity is ($7,200,000 – $2,700,000), or $4,500,000. Equity represents what the business is worth.
|Capital Stock/Partner's Equity||20,000.00||20,000.00||-|
|Opening Retained Earnings||25,530.00||29,129.00||(3,599.00)|
|Dividends Paid/Owner's Draw||(5,000.00)||(5,000.00)||-|
|Net Income (Loss)||8,599.00||9,018.00||(419.00)|
The starting point for using the balance sheet is to understand assets, liabilities and equity.
How Is a Balance Sheet Related to an Income Statement and Cash Flow Statement?
It can be really difficult for a business owner to step back, take a breath and look at the big picture. One big picture concept that’s important to understand is the connection between these three basic financial reports. If you’re clear about how the financial statements connect, you can make better decisions.
Consider the income statement and the balance sheet. 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 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. That makes sense, because earning a profit makes the company more valuable, and equity reports the company’s value in dollars.
In addition, the cash balance in 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: This category accounts for raising money to operate the business and paying 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 assets. If Reliable pays cash for a truck, that’s a cash outflow, and if the company sells some equipment for cash, it’s recorded as a cash inflow.
- Cash activity from operations: This is the “everything else” category, because every cash transaction that is not related to financing or investing is posted here. Not surprisingly, this is the category that accounts for most of Reliable’s cash activity. Paying employees and collecting money from customers are posted here.
The formula for the cash flow statement is:
(Beginning cash balance) plus or minus (cash inflows and outflows for the month) equals (ending cash balance). The ending cash balance is also the cash balance on the balance sheet.
Using Financial Analysis to Increase Cash Flow
For many owners, the most important metric for their business is the amount of cash they need to operate each month. That may be more important to the owner than profit, since no company can operate without sufficient cash. If that’s what keeps you up a night, you can do something about it using financial statement analysis.
Think about it this way: if Reliable Plumbing generates a 15% profit on every dollar sold, which also means that 85% of every dollar sold is an expense. $12 million in sales for the month means that Reliable incurs $10.2 million in expenses. And those expenses have to be paid in cash, either this month or sometime down the road.
A business can generate more cash to operate by reducing the two categories that tie up cash:
- Accounts receivable
Accounts receivable represents money owed by clients, and your inventory balance is the dollar amount of items that you buy for resale. Reliable Plumbing carries a large balance of parts and supplies in inventory, which are used to perform plumbing jobs.
Joe can take several steps to increase cash flow. He can offer discounts to clients who pay quickly and Reliable Plumbing can insist that all customers pay a 20% deposit before any work is performed. The company should also have a formal process for collections, including phone calls and emails to clients who have not paid their invoices. These steps will reduce the account receivable balance and increase cash. QuickBooks Online can help businesses track unpaid invoices, remind customers that a balance is due and take payments via credit card and bank transfer.
Reliable should also take a hard look at the dollar amount of inventory on hand. If Joe’s suppliers can ship inventory items faster, for example, the company can reduce the inventory levels and still meet customer needs. If a supplier can get orders to Reliable in five days rather than ten days, the plumbing company can carry less inventory and simply order more often.
Financial Analysis Pays Off
Taking steps to reduce accounts receivable and inventory levels increases available cash and makes it easier for Joe to manage the business each month. Understanding the balance sheet and its connection to the other financial statements has a big payoff. Joe can make more informed decisions and get better financial results.