Even business owners who are diligent about reviewing their Profit and Loss statement (aka P&L or Income Statement), often spend little to no time looking at their balance sheet. Their bankers, on the other hand, zero right in on it.
Why do business owners overlook their balance sheet? Because they don’t know…
1). what to look for, and
2) how it can help them make better decisions and run a stronger, more profitable business.
Business owners and managers are focused on driving sales and profits, both of which are found on the P&L. Plus, what’s with those mysterious negative balance sheet accounts like depreciation? (We’ll talk about this in a bit.)
Lenders, not surprisingly, are focused on risk. If a business has more debt than it can handle, the banker won’t get paid back for the loans they’ve made. While your P&L doesn’t show your company’s debt levels, its balance sheet does. Hence your banker’s interest in it.
Income Statement versus Balance Sheet
Use the Income Statement to assess if you are: |
Use the Balance Sheet to assess if you are: |
| Driving sufficient sales | Efficiently managing current assets like accounts receivable and inventory |
| Pricing profitably | Paying your bills on time |
| Staffing appropriately | Nearing time to replace equipment |
| Responding quickly to changes in your cost structure | Building cash reserves |
| Controlling expenses | Using debt effectively |
| Earning your target profit | Improving financial condition and complying with loan covenants |
Look at Things from a Lenders’ Perspective
Pretend you are not the owner of the business but rather a banker who’s been approached to lend it money. A diligent banker would examine the company’s balance sheet and see how it is changing over time. Is the business building or depleting its cash reserves? How are accounts receivable and inventory tracking? Is the equipment fully depreciated, and needing to be replaced soon? Your banker-self would also assess the liquidity of the business – that is, whether it has the cash flow to pay its bills coming due. You couldn’t tell any of this from the income statement.
Managing Assets Efficiently
Now put on your owner or manager’s hat. Efficient management of assets is crucial for maintaining healthy cash flow and driving profit. From balance sheet details you can assess how quickly you collect accounts receivable and turn inventory. Accumulating accounts receivable and inventory can adversely impact your cash flow.
Understanding Depreciation
Depreciation is a concept that can be perplexing for many business owners, especially since it appears as a “minus figure” on the balance sheet. Depreciation represents the reduction in the value of fixed assets, such as equipment and vehicles, due to wear and tear and the passing of time. When a company purchases these assets, they are recorded on the balance sheet at their cost. Over time, as the assets are used their value diminishes. This loss of value is referred to as depreciation. Thus, the negative number called accumulated depreciation on the balance sheet reflects the portion of the initial value that has gone away. In theory, the net book value (cost minus accumulated depreciation) should reflect the economic value of the fixed assets today.
The Importance of Having a “Book-to-Tax Difference”
Maximizing depreciation deductions on tax returns is common, legal and prudent. Yet when the maximum allowable deduction is recorded, you are left with a net book value after the first year that is far less than the economic value of the asset. This practice diminishes the value of a company’s assets on paper, to a point where the balance sheet amount does not reflect the economic reality. It is perfectly legal to use different depreciation calculations for the tax return and the financial statements. This is known as a book-to-tax difference. It allows businesses, especially those who take big depreciation deductions, to present a more accurate and profitable financial story to lenders and stakeholders. It ensures that the financial statement reflects the company’s true economic position, while still taking full advantage of allowable tax deductions.
Financial Ratios and Lenders’ Perspective
Let’s go back to the banker’s perspective. Lenders rely heavily on financial ratios derived from the balance sheet to assess a business’s liquidity, risk, and asset efficiency. These ratios offer valuable insights into a company’s financial strength and ability to meet its short and long-term obligations.
The current ratio is one of the critical ratios lenders consider. It measures the company’s current assets against its current liabilities. A high current ratio indicates that the company has sufficient current assets, including cash, to meet its current liabilities, such as accounts payable, tax obligations and debt repayments due in the short-term (one year or less). This reassures lenders that the business has the necessary liquidity to cover its near-term obligations.
Target ratios may be written into your loan covenant. For example, if you have a line of credit secured by accounts receivable and inventory, your credit limit might be limited to receivables that are less than 60 days old and inventory that is less than 90 days old. Better for you to manage and ensure you are in compliance before you get a call from your banker. It is also common for loan covenants to include restrictions on the debt-to-worth ratio (the amount of total liabilities for each dollar of equity).
Produce Actionable Reports
Have we inspired you to start reviewing your balance sheet? Terrific! Here are a couple of suggestions:
- Include columns that show your current month compared to the same month last year
- Include a column for the percentage of total assets.
These allow you to quickly spot trends that impact your cash flow and financial strength, and take quick action to execute on opportunities to improve grow.