How well do you understand your company’s balance sheet? What about your cash conversion cycle? Could you quantify, in real dollars, how much it costs to maintain a certain level of receivables on your balance sheet or that inventory on the shelf? Could you articulate the true cost, or savings, of a loan or line of credit, or do you just focus on the interest paid?
Most business owners feel about as comfortable being asked these questions as they do being asked by their dentist how often they floss. These just aren’t things a typical business owner has the background, let alone the time, to consider. However, learning how your balance sheet works, and more specifically how it works with your income statement, can be the difference between a well-managed company and a company that is truly running on all cylinders.
My goal over the next couple months is to help take some of the mystery out of the balance sheet and make it less intimidating and more useful to business owners who have never quite tapped into its potential.
In full disclosure, this series is intended to be a high-level overview, and not a full-blown dissertation on the nuances of capital optimization. Keep in mind that every company is unique, and if you really want to dive deep into your own balance sheet, the best thing to do is reach out to either your CPA or your banker for guidance. Our team of Business Bankers at Elevations are highly-trained in financial analysis and would be happy to advise you or help explain some of these concepts in more detail. In fact, helping our business members optimize their financial performance is exactly what we do, and it’s how we set ourselves apart from the competition!
What Exactly Is A Balance Sheet, Really?
Most people would define a balance sheet as a snapshot in time of their company’s health. While that definition is certainly correct, it is far from complete. Yes, looking at the balance sheet can quickly tell a business owner how he’s doing in terms of cash, assets, liabilities and net worth, and those are all very important things. However, when we dig a little deeper we will quickly learn that there is so much more to a balance sheet than simply a rundown of assets and liabilities.
The first thing to realize is that a balance sheet is most useful in conjunction with your income statement and vice versa. You simply cannot focus on one and not the other if your intent is to truly understand your business.
Next, the proper way to look at a balance sheet is as a comparison over time, and its power lies in its ability to show a business owner how the different aspects of the business are working, and more importantly, how they are working together. The balance sheet is ultimately the indicator that tells you if the choices you’re making day-to-day are good or bad for the business.
Lastly, everything on your balance sheet is ultimately tied to cash. To get yourself into a balance sheet state of mind, start thinking about everything your company owns and owes as being either a source of cash or a use of cash. In a future blog, we’ll dissect what that means in a lot more detail.
Why Exactly Does My Balance Sheet Matter?
Mike Thomas, the owner and CEO of Alpha Widgets, is stumped that his company is generating record levels of revenue and net income this year, but the bank account balances are the lowest they’ve ever been. How can it be that net income is rising, yet the money in the bank has been steadily decreasing over the past six months? This is where an astute business owner like Mike needs to sit down and figure out what is actually going on in his business. If done properly, the end result is a better understanding of both the real-dollar and opportunity costs of the recent increase in sales and hopefully a very well-informed decision on how to best move forward. How can the balance sheet help us figure out what’s really going on and how to fix it?
One thing Mike does know is it’s been all hands on deck when it comes to making widgets and getting them shipped. Even the receptionist is stuffing boxes full of orders! While the income statement tells a success story (revenue and net income are climbing!), it’s not until we dig into the balance sheet that this becomes a tale of what appears to be misplaced priorities (we’re not actually getting paid for all those sales!).
Mike gets into the office on Monday morning and lays the last six month-end balance sheets out on his desk. His first takeaway is a pretty basic one that almost every business owner can easily recognize; Alpha has been so busy selling widgets that it’s made collecting A/R less of a priority (remember, all hands are on deck shipping all those widgets!). However, while it may be easy to recognize the problem, figuring out the best way to solve it isn’t always easy. Remember, the goal of this exercise isn’t to simply come up with any solution; it’s to come up with the best one. These are the decisions that can really change the trajectory of a company, and Mike doesn’t want to make the wrong choice.
Maybe the answer is to simply redirect one of his employees to focus on collecting A/R, but that impairs Alpha’s ability to fulfill orders. The next logical question is whether hiring someone makes sense. But does Mike hire a collections clerk or another production worker? Another option would be to offer a discount to his customers for paying their invoices faster, and yet another would be to open a line of credit at his bank to help supplement cash. How does Mike decide which of these solutions is the optimal one for Alpha Widgets?
Maybe none of those solutions are the right answer, and instead Mike will learn that his margins are too low. Unless he gets them in line, his company is going to starve to death because they’re causing Alpha to spend its cash faster than it can collect it (did you know that growing too quickly is one of the best ways to kill a company?). How long can the company survive on its current cash levels? What is the right margin for Alpha Widgets? Will putting a line of credit in place actually make the company money, as opposed to cost it money in interest? And what about Alpha’s inventory levels?
The point in asking all these questions isn’t to make the plot of our story more engaging but rather to illustrate that even one of the most basic observations in business (cash is low and A/R is high) oftentimes leads to very complex questions and solutions.
Over the next several weeks, we are going to dig further into Alpha Widgets and help Mike come up with the best solution possible for his company. Take part in this fun and enlightening series by asking questions by tweeting them to us at @ElevationsCU, and subscribe to our Business Banking email list so you don’t miss the next blog in this series!