Small Business Success: 5 Tips For Managing Your Balance Sheet
Most owners are always anxious to receive the monthly financial on how their company is doing. Almost inevitably they turn immediately to the income statement and go to the bottom line to see what the net income was for the month. Then they spend a lot of time reviewing the sales levels and margins and look for variations in expense accounts. This is all well and good but often times their review stops there and they ignore the balance sheet and other financial information.
The balance sheet amounts do not seem to change much period to period so they often get ignored. But delving deeper into the balance sheet and its relationships to the income statement can help answer the following questions.
Budgeting and Projecting Cash Flow
Although net income is an important driver of the business, cash flow is probably an even more important driver and nothing affects cash flow more than the balance sheet. Preparing monthly profit and loss budgets out 12 -18 months can be a tremendous management tool. It becomes even more powerful if you can project out balance sheet accounts and determine cash flow.
- Do you know how to project out working capital needs?
- Do you have a capital budget?
- Do you know to use your balance sheet to help with cash flow?
Do You Understand Working Capital Management?
Working capital is a measure of the liquidity of a company and can also tell a company how much cash they will need to generate to grow.
- Do you understand your working capital turn?
- Do you know how your liquidity compares to your peers?
- Do you know your Current and Quick ratios?
Do You Understand Your Cash Cycle?
Looking at the gross amounts in inventory, receivables and payables often isn’t very meaningful. Much like looking at cost of sales alone isn’t as meaningful as when you look at it in relation to sales and can determine whether your gross margin is improving or not. The cash cycle is a measurement of your cash management efforts. Proper management of your cash cycle can free up funds to reduce invested capital or to invest in new assets.
- Do you know how long you carry inventory for?
- Do you know on average how quickly you pay your vendors?
- Do you know on average how long it takes you to collect from your customers?
- Do you know your total cash cycle?
Many owners wonder how much borrowing capacity their company has available. Available borrowings are often based on collateral, cash flow or leverage which all are impacted by the balance sheet.
- Do you know the collateral value of your assets?
- Do you know your Company’s leverage or debt in relation to equity?
- How does cash flow impact borrowing?
Cost of Capital and Expected Shareholder Return
The mix between the fair value of your debt and equity on the balance sheet can help determine a company’s cost of capital. It is also a reflection of the cost of debt and the cost of equity. Many owners forget that the shareholders should also expect a return on their investment commensurate with the risk taken.
- Do you have an estimate of what return a shareholder should expect?
- Do you know the fair market value of you equity investment?
- Do you know your company’s cost of capital?
- How do you know if you are adding economic value to your shareholders?
All of the above questions can be answered by analyzing your balance sheet accounts or their relationship with income statement accounts. Managing these items if done properly can set you apart from your competitors and embark you on a continuous improvement philosophy implementing best practices.
I’ll delve into the details of the above areas in future blogs.