Don’t forget about the balance sheet!
Small business owners take note. If you want to learn a bit more about the health of your business, look no further than the balance sheet! The income statement might get a lot of the glory when thinking about how the business is doing, but there is a wealth of information regarding the health of your small business right there in the balance sheet.
Small business accounting and the balance sheet
While most of us have a general understanding of what a balance sheet is, we will start with the basics.
Assets reflect what the business owns or has rights to
Liabilities reflect what the business owes others
Equity is the difference between Assets and Liabilities
Ok, that is a pretty simple formula, but what can that really tell me about my business? We could write an entire book about the balance sheet, but wanted to focus this blog post on one of the most important elements of the balance sheet – working capital and accounts receivable.
Working Capital - the lifeblood of small business
Working capital can be broadly defined as the difference between current assets and current liabilities. It can be easily calculated and gives a view into the liquidity that will be available to meet short term needs.
Current Assets consist of a company’s cash, accounts receivables and inventory. Current Liabilities consist of a company’s accounts payable and current portion of long-term loans. When we consider paying off the current liabilities and then consider how much is left in current assets, we can gain an understanding of the financial power that is left in the gas tank. While profitability from the income statement is important to understand the performance of a company, the amount of working capital can provide insight into the future ability to continue to operate. The higher the amount of working capital, the longer the runway is.
How much working capital is needed?
The amount of working capital needed is highly dependent on the type of business. A manufacturing company might need high levels of working capital to purchase inventory which is ultimately turned into saleable products. Those products are then sold and might turn into receivables or cash. The conversion of effort into cash could be quite long in a business like this. Cash will be needed to fund operations until you can ship and collect on your invoices.
A service industry might need lower working capital relative to a manufacturing enterprise but this is also dependent on how the business operates. A seasonal business like a traditional tax firm will collect a lot of cash during the first four months of the year but it might be a bit leaner during the latter parts of the year. So, that type of business would want to hold some of the cash in the business to account for slower times of revenue generation.
How long is it taking you to collect on your invoices?
If you are either having to pay people to produce a service or buy inventory to make a product to sell, chances are you are having to pay these before you get paid by your customer. Your employees and vendors will want to be paid on time so it is important to match the cash flow received from your customers as closely as possible to those cash needs.
One of the easiest measurements of this efficiency is to measure the days of accounts receivable. You can measure this by dividing your total accounts receivable by your average daily sales. The higher the number, the longer it is taking you to convert your work to cash in the bank. A high number of days in accounts receivable is worth spending time on to improve your cash flow and ability to grow the business. While this number may be different by industry, the most important thing here is to get a benchmark of your business’ number and start working on improving it.
Improving days of accounts receivable
As they say in real estate, the money is made when you buy the property. The same idea holds true for accounts receivable – what you do on the front of the transaction is more important than the back end of the deal. How you sell your service or product will have the greatest influence on the number of days of accounts receivable. For example, if your contracts require payment in advance, you will always be in a stronger position than a business that provides payment terms to customers after service delivery. If providing payment terms is an industry standard, then you will need to make sure that your collection practices are consistent and ensure that customers pay on time.
What is holding you back from improving your working capital?
Sometimes, it is just a matter of not knowing where to start. Helping small business owners manage and understand their books is what we do. If you are interested in exploring your balance sheet with a financial professional, feel free to schedule a call and see how we can work together.