I’m consulting with an interior design client right now that has a balance sheet problem.
Most designers don’t consider themselves a “numbers person” and only about 1/3 really examine and understand the P&L statement they receive from their bookkeepers each month. Fewer than that read the other statement that is likely produced, the balance sheet.
Balance sheets also reflect a firm’s position at the instant the balance sheet is produced, whereas P&L statements cover a longer period of time, normally a month.
So, assuming the books are current and accurate, by asking for today’s balance sheet, an analyst or banker can almost immediately answer questions like these about your firm:
What a Balance Sheet Can Reveal
- Does it have sufficient cash on hand to pay its bills?
- Is it well managed in terms of collecting what is owed to it?
- Have the owners invested enough of their own capital?
- Does the firm have too much debt on its books?
- Is there stale inventory on the books?
- How much is the owner reinvesting in the firm versus drawing out?
- What is the “net worth” of this business? (And therefore, in most cases, this business owner?)
Numbers on the P&L statement can fluctuate greatly from moth to month, whereas balance sheet accounts tend to move more slowly.
But while most attention is focused on the P&L statement (sales, costs of goods sold and ultimately, profit) the business owner concerned about the long-term will start learning more about the balance sheet, as that’s where true wealth is created.
A simple place to start is with a ratio called the Current Ratio. Look at your latest balance sheet and find the sub totals for Current Assets and Current Liabilities. Divide the former by the latter to generate a ratio. Example:
Current Liabilities $74,350
$136,500 / $74,350 = 1.84:1
The rule of thumb for the ideal current ratio is 2:1, or Current Assets twice the amount of Current Liabilities.
Like all ratios (and we could look at 20 or more just from your balance sheet!) the key is to be in a range. Neither too high nor too low is better than “just right.” The other key is to use ratios for these three reasons:
- To compare to industry benchmarks (it’s xxx for design firms)
- To compare to yourself, that is, the trend line from quarter to quarter and year to year
- To set goals for improvement.
And how would you improve your Current Ratio?
- Increase cash (collecting receivables faster, for example)
- But also increase receivables (billing faster and more aggressively)
- Increase prices
- Reduce accounts payable (Or permanently reduce overhead expenses)
- Reduce short-term debt
There are other ways, and of course there is a close link between these actions and cash flow. Reducing payables, for example, also reduces cash. (Part of why a balance sheet balances!)
The net worth of your firm (not the same as the value of your firm) increases because assets are increased, liabilities are reduced, and profits are earned. The net worth is defined as Assets minus Liabilities, and profits go straight into the equity side of things as retained earnings. One way of thinking about is that “owner’s equity” is the amount that the company “owes” to its owners. That’s why the famous accounting equation states that: Assets = (Liabilities + Owner’s Equity.)
If you want to really step up your game and become the “numbers person” you need to be, start paying attention to your balance sheet. It’s where true wealth is hidden.