Your balance sheet can be a treasure trove of information that helps you optimize cash flow and run your business more efficiently. It's also important to have your balance sheet in good shape if you want to borrow money or bring on investors. But you have to understand the components of a strong balance sheet before you can improve it.
What makes a strong balance sheet?
A balance sheet can be an effective forecasting tool because it gives you a look at the business's total assets, debts and shareholder equity at a moment in time. It plays a crucial role in your ability to land funding, whether through a loan or an investor. Here are the attributes of a strong balance sheet:
- More assets than liabilities. A cornerstone of a strong balance sheet is having more assets than liabilities. After all, to run a business successfully, you need more money coming in than going out.
- Positive net assets. Net assets are the value of your assets after you pay your obligations. If you have a lot of assets after everything is paid off, your balance sheet is in a strong position. Businesses with positive net assets tend to do better in economic downturns than business with low net-asset positions. Net assets are calculated using this formula: (total fixed assets + total current assets) - (total current liabilities + total long-term liabilities) = net assets.
- Strong assets. Assets alone won't make your balance sheet healthy; they have to be active and valuable to count as positive contributions. You may have a lot of valuable inventory, but if you aren't moving it, it's not worth that much. A strong balance sheet often has assets that provide value now, not potentially later.
- Healthy receivables. You can have all the sales in the world, but if you aren't getting paid in a timely manner, your business can still struggle. Debtors who are slow to pay their bills can really harm a business. Healthy receivables reflect positively on your balance sheet.
- Good debt-to-equity ratio. This 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. The debt-to-equity ratio is calculated by dividing the total liabilities by the total shareholder equity. Shareholder equity, also known as owners' equity, is the amount of money the business owner would get if the business assets were liquidated and all the debts were paid off.
3 ways to analyze a balance sheet
You can glean a ton of information about your business from your balance sheet. By understanding the different aspects, you can improve cash flow, paint a picture of your financial health and help determine if you can handle debt or investors. When you are analyzing your balance sheet, there are some key ratios to look at. They include the current ratio, the debt-to-equity-ratio and the working-capital ratio.
- Current ratio. Calculated by dividing current assets by current liabilities, the current ratio gives you a picture of how much cash you have to run operations. Strive for a current ratio of 1.5 or higher.
- Debt-to-equity ratio. Calculated by dividing total liabilities by shareholder equity, the debt-to-equity ratio shows how much money the business owner needs to cover debt obligations. To have a strong balance sheet, keep this ratio as low -as -possible.
- Working-capital ratio. This is calculated by dividing current assets by current liabilities. Most small businesses will want a positive working-capital ratio; if you have negative working capital, it means you don't have enough cash to bankroll operations and could signal it's time to cut costs or unload assets.
4 ways to strengthen your balance sheet
The balance sheet may not be top of mind for time-crunched small business owners, but strengthening it can go a long way toward improving cash flow and positioning the business for growth.
"A lot of small businesses just look at cash in and cash out," Ben Richmond, country manager at Xero, told business.com. "The balance sheet is important because it gives you the full preview of your business."
The more optimized your balance sheet is, the better off your business will be. If you need cash to chase growth, a strong balance sheet will open doors with lenders and investors. If you wonder if you have too much inventory on hand, take a look at your balance sheet.
There are strategies for optimizing your balance sheet and improving cash flow. Not all of them will fit your unique business, but here are four popular methods to consider:
1. Boost your debt-to-equity ratio.
The less debt and the more cash you have, the better off your business will be. To improve that part of your balance sheet, you need to bring in more sales that you can use to pay down debt, or you'll 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.
"If you get to a really low debt-to-equity ratio, you can use it to raise capital," Richmond said.
2. Reduce the money going out.
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 said to map 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 trim the cash going out, Richmond said.
3. Build up a cash reserve.
In addition to managing the cash going in and out, it's important to monitor the amount of cash held, said Val Steed, director of accountants at Zoho. That's the money a business builds up to use during 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.
4. Manage accounts receivable.
A big challenge for all small business owners is making sure they get paid. The longer bills go unpaid, the more pressure it puts on cash flow. To improve the balance sheet and cash flow, focus on managing receivables, Steed said. 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 a person 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."