Why Every Business Should Have Balance Sheet Know-How
Almost every small business owner I’ve ever worked with can recite their most recent sales figures without so much as glancing at a report. Sometimes the recitation is followed by a nugget of wisdom about sales like, “Every business is either growing or dying.”
Maybe half of these same people could talk to me from memory about the bottom line of their income statement or profit and loss. Presumably, these owners have learned hard lessons on watching profit margins and controlling overhead.
On the other hand, I’ve hardly ever had a small businessperson in my office that volunteered to talk about their balance sheet. Their CPAs may have asked for information on their assets and liabilities for years when it was time to clean up the books at tax time. Their bankers in turn may have asked the CPAs for the latest figures at each new loan application. Still, most entrepreneurs are content to leave the balance sheet to the so-called “numbers people.”
Imagine their surprise when the first year we sit down together for financial review and tax planning, the meeting does not begin with a review of their sales figures or income statement nor a tax projection. No, first we must talk about the balance sheet.
Over the years, a handful of clients have asked why we needed to talk about the assets and liabilities every year. One client who’s sense of humor I knew particularly well received the half-joking response, “We just want to check whether you’re about to go bankrupt.”
What does a balance sheet do?
Predictions of future financial calamity aside, the balance sheet is full of useful information. At the most basic level, a balance sheet shows how the books of a business balance. It illustrates what the business owns (assets), and how it paid for those things (liabilities or equity). Imagine buying a $250,000 house for $50,000 cash down payment and a $200,000 mortgage. The house owned is an asset, the mortgage owed is a liability, and the $50,000 down represents equity.
At the next level, correctly recording assets and liabilities on a balance sheet provides context and deeper meaning to an income statement when making business decisions. Take, for example, a humble janitorial business that records all activity on a very simple, cash-in and cash-out basis profit or loss statement at the end of the year for tax purposes. The company shows a modest profit of just $15,000 for the year. At tax time, the owner tells their CPA that they feel like the business is doing better than that, but they can’t justify keeping it open if it doesn’t earn more than a minimum wage day job.
The CPA would be inclined to agree based solely on the information presented, but what if they had a balance sheet too?
- They might find that the owner has a large balance of accounts receivable (money owed to them by customers), meaning the company doesn’t have a fundamental business model problem. It has a collections problem.
- They might find the client has a ton of inventory on hand, meaning they have a supply chain or purchasing issue, not of a failure of profitability.
- They might find that during the year accounts payable (money owed by them to vendors) was paid down significantly. The company just had a lean year for cash flow because it was paying down old debts, and the owner should consider sticking it out.
A good advisor might find a lot of other things on a balance sheet, too. In the greater sense, they can see and share with clients a bigger picture, with sharper context and deeper understanding than what an income statement or profit and loss can do alone.
How does this keep me out of bankruptcy?
My good-humored client was fortunately not on the way to bankruptcy, but many small businesses are and simply do not see it coming. The balance sheet is an easy-to-prepare financial statement that can help predict this sort of financial calamity and others, if we listen to what it tells us. In the case of long-term solvency issues like bankruptcy, an increase in liabilities without a corresponding increase to assets is a common-sense, easy-to-understand early indicator.
There are lots of good reasons to borrow money in business:
- Sometimes financing is needed for a big expansion or expected future growth.
- Perhaps it’s time to pass the business to the next generation, and funding is needed to secure transition.
- Maybe a temporary obstacle has come along, and the cash on hand is not adequate to bridge the gap.
There may also be dangerous reasons to borrow money:
- Perhaps funds are borrowed for investment without any observable increase in assets or income to show for it?
- Maybe the obstacles just keep coming, and financing is needed for day-to-day operations over a longer period of time.
If your business is in a hole of debt, how do you know when to put down the proverbial shovel and stop digging? Looking at the balance sheet year over year forces a numerical examination of what was borrowed and what the business has to show for it. If the projects you’re financing are showing the expected results and paying for themselves, you should probably stay vigilant but sleep well at night. If you can’t articulate why you’re borrowing or where the money’s going, it’s time to discuss debt management options with your advisors.
Running a business can be a lot of hard work. Adding yet another accounting report to generate and understand might not be for you, but that’s no reason to miss out on the insights waiting on a properly prepared set of financial statements, including a balance sheet.
If you’ve taken more than a few steps down the entrepreneur’s path, you probably already know the value that a trusted advisor brings to the table. At Centennial Tax & Accounting we have the experts you need:
- To teach you to automate your bookkeeping processes using modern software, so you can focus on the business not the books.
- To take full charge of your bookkeeping if needed, cleaning up the mess and maintaining everything in order each month, so you always have top-quality, up-to-date information ready for decision making.
- Help you make sense of the numbers, understand what they mean for your business, and plan for the future.