When most business owners look at their accounts they go straight to the back page and review the detailed profit and loss account. There can be found little gems of information such as gross profit margin (the percentage of gross profit over sales) or you can create other useful ratios to monitor the business such as marketing spend to sales, distribution costs to sales etc….
However when it comes to the balance sheet most clients go blank. What is the balance sheet?
The first thing to note is that it is the one part of your company accounts which are always on the public record (companies only, there is no such requirement for sole traders and partnerships).
Your balance sheet can therefore be accessed by numerous interested parties such as your customers, your suppliers, your employees, finance companies and the general public to assess whether your company is the type of company they would like to do business with. It can also be used by a potential buyer to value your company.
Given all this shouldn’t you be a little interested in having a good balance sheet and to understand what makes a good balance sheet?
Here are my top 6 tips for things to look out for in every company’s balance sheet including your own:
- Make sure your total net assets figure is positive and is growing.
- Make sure your current ratio is greater than 1 and is increasing.
- Make sure your liquidity is greater than 1 and is increasing.
- Make sure that there are no overdrawn directors’ loans distorting the figures.
- Make sure there are good cash balances in the company which are ideally increasing.
- Monitor key ratios such as aged trade debtors and aged trade creditors.
1. Net Assets
Most small businesses start their business with minimal share capital. One hundred £1 shares is common as is just one or two £1 shares. This is your initial risk capital.
Your company then makes a profit (hopefully) which after tax and dividends leaves a retained profit which can be added to previous years retained profits and your initial risk capital.
Your total net assets is the value of all the accumulated retained profits and initial risk capital and is equal to all the assets the business has less all the liabilities. This is the total net assets and ideally it will be positive and growing. The greater the total net assets the stronger the company.
Assets include freehold property, plant and machinery, goodwill and many other fixed assets. These could be financed by long term debt such as hire purchase liabilities and bank loans. The key point to appreciate is that these assets are not easily realisable in the form of cash and the finance does not have to be repaid immediately.
2. Current Ratio
Your current ratio measures your current assets (inventory, trade debtors, other debtors and cash- i.e. assets which will ultimately convert into cash in a very short period of time) and your current liabilities (trade creditors, your VAT bill, corporation tax bill, PAYE bill, loan repayment over the next 12 months etc… i.e. bills your company will need to pay quickly).
The ratio of the assets you can convert into cash quickly against the bills you will need to pay quickly is your current ratio and ideally needs to be greater than 1- i.e. you have more current assets then current liabilities. This ratio should preferably increase year by year which indicates that the company is getting financially stronger.
To be ultra-safe you can monitor the liquidity ratio, which basically takes the inventory out of the current assets. Often inventory can be slow moving and in the event of a liquidation is not usually fully realisable. Companies with very high inventory levels in relation to their total current assets are usually those with real cash flow problems and this indicates a weak business.
Therefore check out the liquidity ratio (current assets excluding inventory divided by current liabilities). A ratio over 1 indicates a strong company and ideally this ratio again should increase year by year.
4. Overdrawn directors’ loans
Take care that there are no overdrawn director loan accounts. This often arises in small companies where the director has extracted too much money from the company, usually through illegal dividends where the company has insufficient profits to declare the dividends. When calculating the total net assets, current ratio or liquidity ratio make sure you remove overdrawn loans from the equations.
Overdrawn director loan accounts are usually bad news and many company balance sheets are propped up with these loans that in practice the directors have little desire ever to repay. If there are overdrawn loan accounts these will always be in the notes to the accounts.
5. Cash balances
Check out the bank balances but beware, a strong cash bank balance is a good thing but can be manipulated by simply not paying suppliers.
6. Key ratios
This then neatly brings us on to monitor ratios. I have already mentioned the current ratio and liquidity ratio but there are numerous others.
Your aged debtors is your trade debtors (net of VAT) divided by turnover and multiplied by 365 days. This gives an indication of how quickly you are paid by customers. 30 days or less is good. Anything over 60 days is worrying and if the debtor days has increased from one year to the next then this could indicate poor credit control.
Similarly aged creditors is the trade creditors (net of VAT) divided by purchases and multiplied by 365 days. A high figure or increasing figure will again indicate poor cash flow and a low figure and reducing will indicate good cash flow.
Building a strong balance sheet is great for your credit rating, it provides assurance to customers, suppliers, lenders and employees alike, and is fundamental in building the value and creating longevity in your business.
If you would like to understand more about your balance sheet and key business ratios then why not speak to your client manager at Friend & Grant Ltd who will be delighted to assist you. Better still, if you are using cloud software why not ask your client manager about building a dashboard to monitor your business’ key ratio both for your balance sheet and your profit and loss using your live information not just your historic data.
If you have any comments you wish to make about this article please email Mark Friend.