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Balance Sheet Health for Your Small Business

Time for a gut check, how is your business, are you working on your business or in your business, or is your business working you? Let’s be honest now, it’s just you and your soul. Are sales slow now for a couple months maybe longer? Do you have what it takes to weather the storm? I know my industry has been slow for a couple years now, as a business owner it is essential that I spot the trends and plan ahead of that trend so I can take the appropriate actions. You will need to do the same with your business, sometimes this is very tough to do.

To first understand the basics of running a business is to know the reason why you should generate reporting from the results of your business activity, in my firm I have separated my sales reporting from the business office. The two departments of my business report independently of one another so that they are objectivity maintained. The sales side includes the process of generating data that can be analyzed to show, current sales, future sales pipeline and the lost opportunities. With each we learn where they come from and why we advanced the opportunities.

From the business office we gather the data to forecast cash flow, P&L and the balance sheet. Understanding a few key balance sheet ratios can provide an excellent picture of what shape your business is in. Because this becomes a snapshot for that period the reports are generated, it is essential to consider the trends that are developing over 30-60 or 90 day period, sometimes even longer.

Let’s start with the basics, understanding the key ratios you will need to keep your eyes on. The current ratio is the primary guide to determine if the company has enough current assets; cash, receivables, and inventory to cover current liabilities; payroll, payments to vendors, taxes etc

If your current ratio moves 6:1 to 2:1 in 6 months you would be trending towards a liquidity crisis. Your reaction to this is determined by the many reasons why this is taking place. Are your receivables slowing, inventory growing or maybe you used cash to buy a new piece of equipment or other asset.   If your current ratio starts to trend the wrong way, you should know what’s going on and take the appropriate actions to get your ratio back in line.

A Current Ratio is the Current Assets vs. the Current Liabilities Anything less than 1:1 is a clear indication of a serious problem, you genuinely want your ratio to be 2:1 and above, this will show you’re in much better shape.

Additionally you should consider a couple more ratios as the measurement in your business overall condition.

Your Quick Ratio is the balance of your Cash plus your Accounts Receivable vs. your Current Liabilities. The quick ratio excludes any inventory you may have.  Hypothetically speaking, if a company had a current ratio of 12:1 then this business showed as its only asset was in its inventory, it would show that is in a very poor financial position. This would make it very difficult for the business to make payroll, pay rent and the vendors. Cash flow is essential in any business, so this will help you in understanding the cash flow position the business is in.

Then there is the Debt to Equity Ratio which equals the Total Liabilities vs. the Net Worth. The debt to equity ratio is a good indication of the financial strength in the business. The debt to equity ratio measures how much of the company is financed through borrowed capitol vs. the owner’s personal investment along with the retained earnings.

For example, take a company with $2 million in assets, they borrowed $1.5 million and had $500K in equity is not as strong as a company with $1million in liabilities and 41 million in equity.

In this example the first company’s debt to equity ratio is 3:1 while the second company is 1:1, this is a big difference.  As the leverage ratio rises, it may become increasingly more difficult to borrow more money, as lenders take a very hard look, especially in today’s business environment at the debt levels a business is carrying.

I hope you will look at your balance sheet objectively enough to stay ahead of the trends for the overall health of your business.
We will talk about the sales side of your business next time.

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