Understanding the Balance Sheet and Why It’s Important

Many business owners focus on the profit and loss statement to assess and improve profitability, often overlooking the importance of the balance sheet. This can be risky because, even if your business is profitable, the balance sheet determines whether your business is solvent. Solvency means being able to pay your bills on time and having assets worth more than your liabilities.

Firstly, what is a Balance Sheet?

A balance sheet is a financial statement that provides a snapshot of a company’s financial position at a given date. It consists of three components being assets, liabilities, and equity.

• Assets: These are resources owned by the business that have economic value. They can be current assets like cash, inventory, and accounts receivable, or non-current assets like property, equipment, and intangible assets.
• Liabilities: These are obligations the business owes to others. Current liabilities include accounts payable and short-term loans, while non-current liabilities include long-term debt and other long-term obligations.
• Equity: This represents the owners’ residual interest in the business after liabilities are deducted from assets. It includes retained earnings and any additional capital invested by the owners.

The balance sheet follows the fundamental accounting equation: Assets = Liabilities + Equity. This equation ensures that the balance sheet is always, well, balanced!

Cash Flow vs. Profit

While both cash flow and profit are crucial for a business, they are not the same.

• Profit is the amount of money left after all costs have been deducted from income. It’s what you see on the income profit and loss statement and is often referred to as the ‘bottom line’. For example, if a bakery sells $1,000 worth of cakes and has $700 in expenses, its profit is $300.
• Cash flow, refers to the actual inflow and outflow of cash in the business. Plenty of businesses have been profitable on paper but still face cash flow problems. For instance, if the bakery has $300 in profit but customers haven’t paid their invoices yet (ie they are Accounts Receivable), the bakery might struggle to pay its suppliers. Add in other payments required that are paid out of profit like, loan repayments, asset purchases, tax and owners’ dividends, then you can see how you can have a profit but potentially have nothing in your bank account.

Understanding the difference between cash flow and profit is very important for business owners. While profit shows your business’s ability to generate income, cash flow ensures you have enough liquidity to meet your financial obligations.

Key Areas of the Balance Sheet to Focus On

1. Profitability

1. Increase Customer Retention: It’s easier to sell more to existing customers than to get new ones. For example, a coffee shop might introduce a loyalty card to keep customers coming back.
2. Generate More Leads: Work on a marketing strategy. Maybe run a social media campaign to attract new customers.
3. Convert More Prospects: Follow up on prospects and turn them into paying customers. For instance, a software company could offer a free trial to entice potential clients.
4. Increase Transaction Value: If you have high volume, low-value transactions, a small price increase can significantly boost profits. Think of a bakery raising the price of its popular muffins by just 50 cents.
5. Increase Transaction Frequency: Encourage repeat purchases. A gym might offer a discount for members who sign up for additional classes.
6. Reduce Variable Costs: Find ways to lower costs without compromising quality. A restaurant could negotiate better prices with suppliers.
7. Reduce Overheads: Cut unnecessary expenses. For example, switching to energy-efficient lighting can reduce utility bills.

Pick one or two strategies that suit your business, focus on them, and watch your profitability grow. You might be surprised how effective small changes can be. Learn more about understanding your profit and loss report here.

Why Profitability Matters Even on the Balance Sheet

Even though the balance sheet is not a profit and loss report, profitability levels are still crucial. Profitability impacts the balance sheet in several ways:

1. Retained Earnings: Profits that are not distributed as dividends are added to retained earnings, increasing the equity section of the balance sheet. This strengthens the financial position of the business.
2. Asset Growth: Profitable businesses can reinvest their earnings into acquiring new assets, which enhances the asset side of the balance sheet.
3. Debt Reduction: Higher profitability allows a business to pay down its liabilities faster, improving the debt-to-equity ratio and overall solvency.
4. Investor/Lender Confidence: Consistent profitability boosts investor and potential lender confidence, making it easier to raise capital if needed.

In essence, profitability fuels the growth and stability reflected in the balance sheet, ensuring the business remains solvent and financially healthy.

2. Cash Flow – Cash is King!

Businesses with a cash buffer are better equipped to handle business challenges. Building up cash reserves means optimizing key areas of your business so your Cash Conversion Cycle is as short as possible. The Cash Conversion Cycle is the time cash is tied up in stock and accounts receivable.

Here are some strategies to reduce the days in your Cash Conversion Cycle:

• Negotiate Extended Payment Terms: Hold on to your cash longer. For example, a retailer might negotiate 60-day payment terms with suppliers instead of 30 days.
• Optimize Inventory: Ensure inventory isn’t sitting around too long. A clothing store could have a clearance sale to move out last season’s stock.
• Speed Up Work in Progress: Complete and bill work quickly. A construction company might streamline its processes to finish projects faster.
• Collect Accounts Receivable Quickly: Follow up on overdue amounts promptly. A freelance designer could send reminders for unpaid invoices.
• Offer Discounts for Early Payments: Encourage faster payments. A wholesaler might offer a 2% discount for payments made within 10 days.
• Require Payment via Credit Card: Ensure control over when amounts are collected. An online store could require credit card payments to avoid delays.

3. Solvency

Solvency means being able to pay your bills on time and having assets worth more than your liabilities. Your business’s success relies on maintaining solvency. Here’s how to assess solvency and take action if needed:

1. Calculate Your Current Ratio: Current Ratio = Current Assets / Current Liabilities. A ratio less than one means you don’t have enough current assets to pay your current debts, indicating insolvency.
2. Assess Total Assets Minus Total Liabilities: If the result is negative, your business needs a short-term cash injection.

In either case, take immediate action to increase assets. Avoid agreements that could risk creditors if your business is insolvent.

4. Shareholder Current Accounts

Shareholder Current Accounts (aka Shareholder Advance Accounts) can be both an asset or a liability in the balance sheet. If the Shareholder Current Account is an asset, it means shareholders have taken more out of the business than they’re entitled to. Essentially, the business has extended a loan to shareholders. This is risky because if the business fails, liquidators can insist that this loan be repaid from the shareholders’ personal assets. There’s also a tax obligation to charge shareholders interest on any money loaned to them as it is seen as a Fringe Benefit.

Shareholders should avoid an overdrawn Shareholder Current Account by reducing the amount of drawings they take from the business and sticking to a regular amount each week or month. Discipline is required. Conversely, if shareholders advance money to the business, it’s important these are secured so that in the event of liquidation, they stand a better chance of getting their money back. Learn more about shareholder current accounts and drawings here.

What’s Next?

We hope this article helps you see that understanding the balance sheet is just as important as understanding the profit and loss. Take some time to review profitability, cash flow, solvency, along with shareholder advance accounts to ensure everything is optimized.

If you need further assistance to understand these concepts, strategies or to calculate ratios, please get in touch. Business Like NZ has been providing professional, yet affordable tax and business advice to the Auckland region and beyond for years!