Your balance sheet (now more correctly called a Statement of Financial Position) reveals a great deal about your business, including the total value of your assets – the things you own; how much you owe to others – your liabilities; and the level of your solvency.
If you intend to sell your business, these three aspects will be studied carefully by lenders and investors − and by buyers. But they should also be important to you because it’s crucial to be solvent. In other words, you need to have more assets than liabilities available to pay your debts.
If you can’t pay bills when they fall due, your business may be technically insolvent. Fortunately two simple tests can quickly reveal your solvency.
This test involves dividing your assets by your liabilities (you should find both figures on the balance sheet). For example, if a business has assets of $435,000 and liabilities of $180,000, the current ratio is 435,000 divided by 180,000 = 2.42.
In other words, the business has $2.42 in assets for every $1 of debt. On the face of it, the company is solvent, as the minimum ratio most banks would regard as acceptable is $2 for every $1 of debt.
But wait a minute. Your assets include stock (your inventory). What’s your stock worth? If you had to sell it all tomorrow to pay off your debts, could you get the full amount shown on the balance sheet?
Let’s try a stricter test, leaving out your stock. The aim is to determine if your business has enough quick money (ready cash) to pay your bills if your creditors demand repayment tomorrow. Let’s say the company has $325,000 in stock. Subtract this from the assets figure of $435,000, and the assets reduce to $110,000.
Now for the Quick Ratio: $110,000 divided by $180,000 = 0.61.
Hmm − the picture is no longer so rosy. The business has only 61 cents in ready cash for every dollar of debt, meaning it could not immediately pay its debts.
Your aim should be to have at least $1 in assets available in quick cash for every $1 of debt, a ratio of 1:1. You’ll sleep better, and so will your bank manager.
Strengthening your balance sheet
A positive step to strengthen your balance sheet is to take a closer look at the quality of your inventory. If you had to sell all your stock in the next week or month to pay your debts, would you get the total amount shown on the balance sheet? In many businesses, the answer would be no.
If you know you have obsolete or slow-moving inventory sitting on your shelves, talk to us about ways to get rid of it. We can discuss ways to reduce or get rid of obsolete stock, such as:
We can also show you how to measure the stock turn rate in your business to improve stock management and profitability. In broad terms, the faster you turn over your stock, the more efficient your company. A fast turnover rate can also reflect more efficient inventory management.
Closing tips
Donna Bordeaux, CPA with Calculated Moves
Creativity and C.P.A.s don’t generally go together. Most people think of C.P.A.s as nerdy accountants who can’t talk with people. Well, it’s time to break that stereotype. Lively, friendly, and knowledgeable can be part of your relationship with your C.P.A., as Donna and Chad Bordeaux demonstrated. They have over 50 years of combined experience as entrepreneurial C.P.A.s. They’ve owned businesses and helped business owners exceed their wildest dreams. They have been able to help businesses earn many times more profit than the average business in the same industry and are passionate about helping industries that help families build great memories.