Importance of the Balance Sheet

Why do I need to understand my Balance Sheet?

Often business owners focus on the Income Statement as the main source of assessing and improving profitability neglecting to recognise the importance of the Balance Sheet.

This can be dangerous because although your business may be profitable, it is the Balance Sheet that will determine whether your business is solvent.

(Solvency refers to the ability to pay your bills as they fall due and having assets that are of greater value than your liabilities).

Importance of the Balance Sheet

In this month’s article, we will discuss 4 key area of the Balance Sheet that you should focus on to maximise the success of your business:

Don’t let your business go broke!

Take the time to understand your Balance Sheet by starting with this article and then give us a call if you’d like some help to dive a bit deeper and put strategies in place to grow your business.

Profitability

How can you increase the profitability of your business?

There are seven common strategies you can focus on which will help to increase profits. They are:

  1. Increasing customer retention – It’s easier to sell more to existing customers than it is to get new ones – so good customers are definitely worth keeping.
  2. Generate more leads – Perhaps you need to work on a marketing strategy?
  3. Convert more prospects – Put workflows in place to follow up on prospects and convert them into paying customers.
  4. Increase transaction value – If you have high volume, low value transactions, a small price increase will convert to a big increase in profits. Perhaps you’re simply under selling your products and services and need to charge a bit more?
  5. Increase transaction frequency
  6. Reduce variable costs
  7. Reduce overheads

Choose one or two that are best suited to your business, focus on them and use them to increase your profitability.

You may be surprised how effective some subtle changes and a concerted effort can be…

2) Cashflow

Cash is King! An old but very true saying.

Businesses that maintain cash reserves are well placed to weather economic challenges.

Building up cash reserves relies on having key areas of your business optimised and functioning effectively so that your Cash Conversion Cycle is as short as possible. The Cash Conversion Cycle refers to the time cash is tied up in Stock and Accounts Receivable.

Some strategies for reducing the number of days in your Cash Conversion Cycle are as follows:

  • Negotiate extended payment terms with your suppliers so that you can hold on to your cash for as long as possible.
  • Make sure your inventory is not sitting around in the warehouse too long and therefore costing you money rather than making you money!
  • Make sure any work in progress is completed and billed to the customer as quickly as possible.
  • Collect any Accounts Receivable as fast as possible!
  • Have a great credit controller who is not afraid to follow up overdue amounts promptly.
  • Consider offering discounts for early payments.
  • Consider requiring payment via credit card to ensure you have control over when amounts are collected.

These strategies will help you build a stronger Balance Sheet by increasing your cash on hand.

3) Solvency

Solvency refers to the ability to pay your bills as they fall due and, having Assets that are of greater value than your Liabilities.

The success of your business relies on maintaining solvency.

Make sure you understand the steps below on how to assess solvency and be ready to take action immediately if you get into a situation where steps need to be taken.

1. Calculate your Current Ratio

In order to assess whether you have the ability to pay your debts as they fall due, you can calculate your Current Ratio.

Current Ratio = Current Assets divided by Current Liabilities.

A ratio less than one means you don’t have enough current assets to pay your current debts as they fall due and that your business is insolvent.

2. The second part of the test is as follows:

Total Assets minus Total Liabilities.

If the result is negative, this means that your business requires a short-term cash injection.

In either circumstance action must be taken immediately to increase assets. No agreements should be entered into by directors that could create risk to creditors if you are aware that your business is insolvent.

4) Shareholder Advance Accounts

Shareholder Advance Accounts can be both an Asset or a Liability in the Balance Sheet.

If the Shareholder Advance Account is an asset, this means the shareholders have taken more out of the business than they are entitled to. Essentially, the business has extended a loan to shareholders.

This is a risky move by shareholders as it means that if the business were to fail, liquidators can insist that this loan be repaid from the shareholders personal assets. There is also a legal obligation to charge the shareholders interest on any money loaned to them. This interest is assessable to the Company for tax purposes, but non-deductible to the shareholders.

Shareholders should ensure they avoid an overdrawn Shareholder Advance Account by reducing the amount of drawings they are taking from the business and sticking to the reduced, regular amount each week or month.

On the flip side, if shareholders advance (or loan) monies to the business, it’s important that these are secured so that in the event of a liquidation, they stand a better chance of getting their money back.

Importance of the Balance Sheet – Conclusion

We hope that you have a better understanding of the importance of the Balance Sheet after reading this article.

We recommend you take some time reviewing Profitability, Cashflow, Solvency and Shareholder Advance Accounts to ensure everything is optimised and in order.

If you would like further assistance to understand any of these concepts or to calculate ratio’s, please get in touch.

It’s our passion to help businesses grow and thrive – We’d love to hear from you!