The Value of Understanding and Reading a Balance Sheet
You might be surprised how many small business owners do not pay attention to their balance sheet and focus solely on the Profit and Loss Statement (P & L). Some business owners I have coached have stated they ignore it entirely. Let me be clear, this is a really bad idea, but relatively easy to solve.
Here is an official definition of a Balance Sheet.
“A balance sheet is a snapshot of a business’s financial condition at a specific moment in time, usually at the close of an accounting period”.
A balance sheet comprises assets (what you own), liabilities (what you owe), and owners or stockholders equity (the value of the business you own). As the equation demands; assets always equal liabilities plus equity. That’s why it’s called a balance sheet….. Duh….
Why Should Any Business Owner Care About Their Balance Sheet?
Here are four examples
- First of all, due to the rules of double entry bookkeeping, correcting any discrepancy in the balance sheet usually affects the P & L. So, to get an accurate P & L you need an accurate balance sheet.
- The balance sheet is a critical document because it keeps you informed about the company’s financial health. Sure, the P& L shows whether the company is making profit, but the balance sheet provides a wealth of information that can be used to run a healthy business.
- The balance sheet is the first way anyone outside the business makes an evaluation. For example, do you need a loan? Do you need a new investor? Do you want to sell your business? In any of these instances, the balance sheet is the first document that will be analyzed. So not only do you need it be accurate, you need to know all the balance sheet components and ratios in order to have meaningful discussions, and respond intelligently to their questions
- Lastly, there are a number of key ratios you need to be aware of that determine the financial health of the business. Here are a couple of examples, however there are many, many more:
- The ratio of current assets to current liabilities gives you your working capital ratio (sometimes known as liquidity, or quick ratio). If that is less than 1:1 you are in danger of going bankrupt. If is not much more than 1:1 it is indicative that you are cash strapped and will not be able to repay a new loan.
- The ratio of debt to equity is another important one. It is used to measure a company’s financial leverage (borrowing capacity), calculated by dividing a company’s total liabilities by its stockholders’ equity. Generally, a ratio no greater than 2:1 is considered ideal. This means the total debt should not be greater than twice the shareholder’s or owner’s equity.
How to Gain the Practical Knowledge you Need to Read and Understand a Balance Sheet.
Don’t give into any myths. You don’t need to take accounting courses to get this knowledge. A couple of hourly sessions with the right person is a great start. Here are some options
• An accountant who has worked in mergers and acquisition activity.
• A friend who is a commercial loan officer.
• A friend who is an accomplished and successful business person.
• A business coach.
To summarize it all, whether you are an entrepreneur, business owner, executive or manager, having accounting knowledge, without going into all the accounting rules and regulations, is a key to making informed decisions. One of my strongest skillsets is accounting, so this is knowledge I can accurately provide. To be frank, I don’t particularly enjoy pure accounting, but it provides a great foundation for dealing successfully with business matters. In the last few companies I owned, I made sure we ran open books and I held basic accounting knowledge courses on balance sheet, P&L and cash flow interpretation so my employees could be fully engaged in understanding and contributing to the success of the company. It was essential to the success of my companies, and is just as important to yours.