How to Decode Your Balance Sheet

Do you know the story your Balance Sheet tells you about your business? If you’re not familiar with it, it may seem confusing at first, but it’s actually not that hard once you understand what to look for. Along with other reports, the Balance Sheet can be a powerful tool to help you make smart business decisions.

Let’s look at how you can use the Balance Sheet to measure the health of your business.

The Balance Sheet measures the net worth of your business

Your Balance Sheet represents all of your assets, liabilities and equity, which is also known as net worth. Your net worth is your total assets minus total liabilities. If you are not familiar with those terms, here’s the explanation on our blog Why Do You Need to Understand Your Financial Reports.

Assets and liabilities fall into two categories:

  • Current assets are assets that can reasonably be expected to be converted into cash within 12 months, whereas current liabilities are liabilities that are expected to be paid within 12 months.
  • Non-current assets are those considered long-term and not expected to be converted into cash until at least a year. Similarly, non-current liabilities are long-term liabilities, which aren’t expected to be paid within 12 months.

Your net worth is the owners’ interest in the business. If your business liquidated all of its assets and paid off all the liabilities it owed, the amount left over would be your net worth. This is how much you would be left with as the owner of the business.

The Balance Sheet tells you if your business is solvent

Solvency is the acid test for survival. If your business is insolvent, without immediate action to remedy this, it’s unlikely to survive for long. There are two components to solvency:

  • Current ratio greater than one (current ratio = current assets / current liabilities).
  • Positive net assets (net assets = total assets – total liabilities)

If your business is insolvent, you will struggle to pay bills on time and you may be personally at risk. It is imperative you see help if your business is insolvent.

The Balance Sheet allows you track the strength of your business

By comparing your Balance Sheet to previous periods, you can track whether your net worth is increasing or decreasing. The stronger the Balance Sheet, the easier it will be for your business to survive a downturn. For example, if your retained earnings are diminishing over time, you need to take action to strengthen your Balance Sheet to ensure you will receive value when you wind up or sell your business.

Calculating key ratios

Key ratios allow you to compare your results to previous years, help with industry benchmarking, and highlight areas for improvement.

For example, calculating your debtors days may show that it takes on average 30 days for customers to pay you. If your payment terms are within 7 days, your debtor processes need improvement. Perhaps you calculate how long it takes inventory to sell and see it takes twice as long to sell this year than it did last year, or maybe a specific product is taking longer to sell than others. This may indicate that you should discontinue it.

Key ratios calculated from your Balance Sheet can tell us a multitude of things.

Every business owner should be able to read their Balance Sheet and understand what it’s telling them. If you need help to decode your Balance Sheet and identify key areas for improvement, get in touch, so we can organise a time to explain it all to you.

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