Using your Balance Sheet to Better Understand your Business

In the next two blog posts, we’ll be focusing on how the Balance Sheet can help you better understand your business.

Part One: What’s Your Current Ratio?

Balance Sheets are often overlooked by small business owners, but they’re a valuable tool for understanding the bigger picture of your business’ financial health.

First, we’ll use the Balance Sheet to better understand your business by analyzing liquidity. By comparing Current Assets to Current Liabilities, we can see the business’ ability to repay its short-term obligations. This calculation is called the Current Ratio.

How familiar are you with these two components of a Balance Sheet?  

Current Assets

Assets that are convertible to cash within a year.

Examples: 

Cash and Cash Equivalents

Accounts Receivable

Marketable Securities (Stocks, Bonds and Mutual Funds)

Inventory

Current Liabilities   

Loans and Vendor Bills that are due within a year. 

Examples: 

Accounts Payable

Short-Term Loans (Lines of Credit, Accrued Expenses and Customer Deposits)

 

Hot tip: In your Current Liabilities total, be sure to include the Current Portion of Long-Term Debt, which is 12 Months of payments due on Long-Term Loans (Building Mortgages, Equipment, and Vehicle Loans).  

 

Understanding the Current Ratio

A Ratio greater than 1 indicates that the company has sufficient Current Assets to cover its Current liabilities. Generally, a higher Current Ratio is desirable as it suggests a better ability to meet short-term obligations. A Ratio that is less than 1 indicates a company could be in financial trouble as there aren’t enough liquid Assets to cover its next 12 months of debt payments.

3 Reasons Why The Current Ratio Is Important

• Keeping track of your Current Ratio over time will help you identify early warning signs. The trend of a decreasing Ratio tells you that your debt is outpacing your Assets. You will want to begin asking questions such as…are we buying too much inventory? Have our sales dropped? Are we not collecting on our receivables? Asking yourself these questions will lead you down a path of evaluating each area of your business until you get to the root of the problem.
• If you need financing, the bank is going to look at your Current Ratio. While their requirements will vary by industry, they typically want to see something around 1.2 or higher.  If you work with a business banker now, reach out to ask them what their standard is so you have a goal.
• Looking for an investor or thinking about bringing on a partner? They should be evaluating your Current Ratio to see if it makes sense to join your enterprise. A business that can pay its short term obligations is more likely to be successful.

One last tip: Track your Current Ratio as a trend over time, not just a random snapshot once in a while.  Check out this sample graph showing how the Current Ratio can vary quite a bit over 12 months. 

 

Takeaways

• Begin calculating and tracking your Current Ratio
• Set a goal to raise your Current Ratio higher than a 1

Stay tuned for Part Two: How are your liabilities trending? to continue learning how you can use your Balance Sheet to better understand your business.