A savvy investor or banker can glance at a balance sheet and quickly tell how well the business is doing. Numbers don’t lie. That’s why you need to have your balance sheet in good shape if you want to take out a business loan or attract investors. This article will walk you through how to construct a fortress balance sheet — one that stands strong against sudden financial crises. A strong balance sheet can make your business an attractive investment for growth and secure your future.
A balance sheet provides a snapshot of your business’s total assets, debts and shareholder equity at a moment in time. It plays a crucial role in your ability to secure funding through a loan or investor. These are the main attributes of a strong balance sheet:
Before you analyze your balance sheet, you need to learn a few key accounting ratios. These include the current ratio, the debt-to-equity ratio and the working capital ratio.
Your business’s current ratio, calculated by dividing current assets by current liabilities, shows how much cash you have to run operations. Strive for a current ratio of 1.5 or higher.
This ratio measures the amount of shareholder equity available to cover the business’s debts. The lower the ratio, the better a company is positioned to weather an economic downturn. Your debt-to-equity ratio is calculated by dividing total liabilities by total shareholder equity. The statement of shareholder equity, also known as owners’ equity, is the amount of money the business owner would receive if the business assets were liquidated and all the debts were paid off. Keep this ratio as low as possible for a strong balance sheet.
This is calculated by dividing current assets by current liabilities. Most small businesses want a positive working capital ratio. Negative working capital means you don’t have enough cash to bankroll operations and could signal that you need to cut operational costs or unload assets.
Try calculating these ratios by hand at least once a month to keep them fresh in your mind.
Thinking about balance sheets isn’t the most exciting part of being a small business owner. However, if you want to position your business for growth or increase cash flow, building a fortress balance sheet should be a serious goal.
“A lot of small businesses just look at cash in and cash out,” Ben Richmond, country manager at Xero, told us. “The balance sheet is important because it gives you the full preview of your business.”
Every business is different, so there is no one-size-fits-all solution for strengthening your finances. Consider using some or all of these strategies to improve your cash flow statement and balance sheet.
It’s common sense that a business is generally better off with less debt and more cash on the balance sheet.
“If you get to a really low debt-to-equity ratio, you can use it to raise capital,” Richmond said.
To improve that part of your business’s assets, you need to bring in more sales that you can use to pay down debt. You may also have to unload assets, such as office equipment or real estate property. Boosting your debt-to-equity ratio will strengthen your balance sheet, improve cash flow and put you in a position to pursue growth.
A cash-flow deficit will quickly spell a small business’s demise, which is why reducing the money going out is an effective way to improve your balance sheet and bottom line. To optimize cash flow, Richmond advised mapping out different scenarios for the cash going out of the business, including the worst-case, best-case and likely scenarios. If your likely scenario looks a lot like the worst-case scenario, find ways to drastically cut business costs, Richmond said.
Negative cash flow occurs when there is more cash flowing out of a business than coming in.
In addition to managing the cash going in and out, monitoring the amount of cash held in your business savings account is crucial, said Val Steed, director of accountants at Zoho. You can use that pot of money for emergencies or to take advantage of an unexpected opportunity. Without cash in reserve, you might need to scramble to secure financing quickly.
“My general rule of thumb is, until you build up your hold or protective balance, one-third goes back into operations, one-third is invested back into the business to improve growth, and one-third is the hold,” Steed said.
Getting paid is a big challenge for all small business owners. The longer bills go unpaid, the more pressure it puts on cash flow. Steed said to improve the balance sheet and cash flow, focus on managing receivables. That doesn’t mean sending out a bill reminder email and leaving it at that. Nor does it mean asking your salesperson to try collecting the amount owed. Rather, it requires you to put someone in charge of collecting overdue bills using persistence, patience and politeness.
“Never put a salesperson back on a bad account,” Steed said. “The salesperson stays in the good-guy role at all times.”
You should strongly consider using top small business accounting software to fine-tune your business’s finances. Accounting programs can generate balance sheets and cash flow statements automatically, as opposed to creating them by hand. Software also reduces human error and eliminates inefficient manual data entry.
The best accounting software is easy to use and able to integrate with your bank and other business apps. If you implement small business accounting software, you can significantly simplify your finances and put yourself on the path to building a solid balance sheet.
Mike Berner contributed to this article. Some source interviews were conducted for a previous version of the article.