The Importance in Knowing Your Balance Sheet

Hi there fellow business owners,

Your financial reports tell you the story of your business; allowing you to interpret the results of your business activity. The better you understand your financial reports, the better your decision-making and results will be.

We want to share the benefits of understanding your numbers, give you an overview of the standard reports and provide helpful tips on using them to improve your business. Where possible, we’ve avoided jargon and ‘Accountanese’, however, if you need further support or guidance from us, please do get in touch.

The benefits of knowing your numbers

Knowing your numbers will allow you to:

• Understand whether your business is growing or shrinking Track trends over time
• Compare results to your expectations (as set in your budget) Compare results between years or different periods
• Identify areas of strength and weakness Measure your business efficiency Measure the value of your business Identify symptoms of underlying problems
• Measure your cashflow
• Make better business decisions

“You don’t have to be an accountant or bookkeeper to understand your numbers; just as you don’t have to be a mechanic to drive a car.”

Knowing your numbers puts you in a far stronger position to make informed decisions and measure the impact of those decisions on your results, enabling you to take corrective action.

This guide is designed to be general in nature and is no substitute for specific one on one advice. We strongly recommend you talk to us about your unique situation and how we can help you improve your business.

Your key financial reports

The rest of this guide provides an overview of your key financial reports, what each report tells you about your business, some key ratios to use to track your results, and some tips on how to make good use of the reports.

Key ratios:

By calculating key ratios, you can compare your results over a number of periods, compare the profitability of different product lines, divisions or locations, and compare your results to your industry benchmarks. All of this provides information which should be used in your decision-making. It’s important to only compare your ratios with companies in the same industry; what may be viewed as a ‘good’ ratio for one industry, may be ‘poor’ in another.

Below is an overview of the following reports:

• Balance Sheet.
• Statement of Changes in Equity.
• Shareholder Current Account.

BALANCE SHEET

Your Balance Sheet, or Statement of Financial Position, measures the net worth of your business at a point in time and shows if your business is solvent (if assets are greater than liabilities).

It details assets, liabilities, and shareholders’ equity (funds contributed by shareholders and accumulated profits not yet paid out as dividends). In many ways, the Balance Sheet is more important than your Profit & Loss as it shows:

1. The overall health of your business.
2. If your business is appropriately resourced from a financial perspective.
3. Areas of strength (and weakness).
4. How the business is financed – both from shareholders and financiers.
5. The cash reserves available.
6. The assets employed and investments made.
7. The level of debt outstanding to creditors, the tax department and financiers.
8. Amounts owed to shareholders.

The basic format for your Balance Sheet is:

Equity (retained profits and reserves) = Total Assets – Total Liabilities

It’s called a Balance Sheet because the ‘Net Assets’ (Total Assets less Total Liabilities) should always balance with the Equity. If these don’t, let us know as we love fixing problems like these.

Breaking this format down further we have:

Total Assets= Current Assets+ Non-current Assets

Current Assets	Cash, bank accounts, stock/inventory, tax refundable, debtors, work in progress.
Non-current Assets	Investments, goodwill, loans made to other parties, fixed assets.

TotalLiabilities=CurrentLiabilities+Non-currentLiabilities

Current Liabilities	Creditors, overdraft, loans repayable within a year, tax payable.
Non-current Liabilities	Term loans, shareholder loans/advance accounts.

If Total Liabilities are more than Total Assets, your Net Assets will be negative, and your business is insolvent. In this case, please contact us urgently so we can advise you on what needs to happen. There are serious consequences for you if your business is insolvent.

“A strong Balance Sheet (where net assets are high) means your business is better equipped to weather a storm or continued downturn in the economy.”

Key Ratios:

Current Ratio = Current Assets / Current Liabilities

The Current Ratio, also known as your Working Capital Ratio, shows whether the company can meet its short-term obligations with its Current Assets if they all fell due at the same time. A ratio of 0.8 means that for every $1 of Current Liabilities, there’s 80c of Current Assets to cover them. A ratio of 2.5 means that for every $1 of Current Liabilities, there’s Current Assets of $2.50, therefore there wouldn’t be a problem paying short-term obligations.

However, a high Current Ratio could indicate the inefficient use of Current Assets or poor working capital management. The key is to compare the ratios across different periods or with companies in the same industry. To improve your Current Ratio, consider strategies such as better controls on expenditure, faster invoicing of work done or restructuring your overdraft into a long-term loan.

Debtor Days = (Debtors / Sales) * 365

This shows, on average, how many days it takes customers to pay you. The lower the number, the better, as your cash isn’t tied up in your debtors and you’ve reduced the risk associated with bad debts / collection costs.

Calculate Debtor Days using Sales for the entire year and Debtors at month end. For example, if Debtors are $80,000 and Sales are $1,000,000, Debtor Days will be 29. How good this is depends on your payment terms; if they state payment within 7 days, 29 days is well above this and corrective action should be taken.

If your policy is payment on the 20th of the month following invoice, then you may consider 29 days to be fine. The reality is that 29 days is not fine. Using the above example, 10 days of debtors represents $27,397 of cash you could have in your bank account (Sales / 365 x 10 days). If Debtor Days were reduced to 19 days, you’d have an extra $27,000. Your terms should ensure you get paid as fast as possible. Payment within 7-14 days is standard.

Inventory Days = (Inventories / Cost of Sales) * 365

This shows how long it takes you to sell your stock, in other words, the number of days that cash is tied up in inventory. The lower the number, the better. For example, if your Inventory is $50,000 and your Cost of Sales is $350,000, your Inventory Days will be 52. This means that, on average, inventory sits for 52 days before being sold.

To reduce your Inventory Days, review your inventory processes and identify slow-moving stock. Consider whether you should discontinue this, or only hold a display model in store and order stock on demand.

Debt to Equity Ratio = Total Liabilities / Shareholders’ Equity

The Net Assets value in your Balance Sheet represents your Shareholders’ Equity (Total Assets – Total Liabilities). The Debt to Equity Ratio shows how a company has financed its growth. A high ratio means it has mostly been funded by debt; a low ratio means it’s funded more by shareholders and is more sustainable.

While debt is often necessary to help a company grow, high levels of debt put the company at a higher risk. Do the returns generated from the debt outweigh the cost of the debt? For example, if Total Liabilities are $750,000 and Shareholders’ Equity is $200,000, the Debt to Equity Ratio is 3.75. This means that the company has $3.50 of debt for every $1 of equity. In most industries, this would be considered very high risk, however, it could also indicate expansion, leading to increased revenue in the future. On the other hand, a very low Debt to Equity Ratio may indicate a lack of growth.

Balance Sheet Tips:

• Cash is king. Having large amounts of cash tied up in inventory, debtors, or work in progress can be a large drain on cash reserves. Worse still, it’s likely you’ve already paid tax on these amounts. Talk to us about how to convert inventory, work in progress and debtors into cash faster and what it will mean for your business.

• Shareholder loans can be your friend or foe. A shareholder loan, or Shareholder Current Account, is the amount owed to the shareholder by the company. These loans should show as a liability in the Balance Sheet as they form part of the financing of the business. If they’re showing as assets, it means the shareholders owe that amount to the company. This is a high risk situation. If the company gets into financial difficulties, a receiver or liquidator can demand this money from the shareholder, who will no longer have the protection of limited liability.

• Know your key ratios. These are different for each business and there may be some variation in how they’re best calculated for your business. It’s common to put the key ratios into your Business Plan to track your results over time. Talk to us about the best key ratios for your business.

• What is the true net worth of your business? Unless you’ve correctly valued goodwill, you won’t get a true valuation of the business by only looking at your Balance Sheet. Create a ‘rule of thumb’ valuation formula that you can adopt to assess your goodwill each year. This rule of thumb can then be used as a guide as to whether your business value is increasing or decreasing. Talk to us about an appropriate rule of thumb to track valuation movements over time.

STATEMENT OF CHANGES IN EQUITY

The Statement of Changes in Equity records what happens to any profits for the year; whether they are paid out as dividends or kept in the business as retained earnings. Generally speaking, the higher the equity, the better for the company. However, shareholder loans can also be treated as part of the equity. Therefore, it’s possible that, while the company is technically insolvent (more liabilities than assets), if the shareholder loans are recorded as equity, the company is effectively relying on the shareholders to pay its debts as they fall due.

The basic format for your Statement of Changes in Equity is:

Total Equity = Opening Balance + Gain on Sale of Fixed Assets + Profit – Dividends Paid – Loss

Opening Balance	The equity position from the end of the last financial year.
Gain on Sale of Fixed Assets	Where assets have been sold for more than their cost.
Profit for the Period	Carried forward from your Statement of Profit & Loss.
Dividends Paid	Any dividends paid out to shareholders during the year.
Loss for the Period	Carried forward from your Statement of Profit & Loss.
Total Equity	The equity position at the end of the period.

If Total Equity is negative, the company is insolvent and cannot pay out any dividends. The directors must take action to increase the profitability of the company.

SHAREHOLDER CURRENT ACCOUNT

This records all funds introduced to the business by shareholders, credited to shareholders as dividends or salary, or taken out of the business as drawings. The Shareholder Current Account is also called a Shareholder Loan as it’s a debt owed by the company to the shareholder(s). Where a company has multiple shareholders, it ensures a record of different balances for each shareholder is maintained.

The basic format for your Shareholder Current Account is:

Closing Balance = Opening Balance + Funds Introduced – Drawings – Insurance

Opening Balance	Balance owed by the company to shareholders from the end of the last financial year.
Funds Introduced	Cash or assets invested into the company by shareholders.
Drawings	Cash withdrawals, assets taken from the company by shareholders, personal expenses paid by the company on behalf of the shareholders.
Insurance	Personal insurances paid by the company which aren’t tax deductible by the company, e.g. life insurance.

The balance of each Shareholder’s Current Account represents the amount the business owes that shareholder. If the balance is negative, the shareholder has taken out more than they’ve put in, and owes the company money. It’s important to monitor your Shareholder Current Account and understand the potential tax implications of it being overdrawn.

To remedy an overdrawn Shareholder Current Account, a shareholder could repay the amount owed, declare a shareholder salary, or declare a dividend. The company must be solvent for a shareholder salary or dividend to be declared.

Shareholder Current Account Tips:

• Consider security. As funds owed to shareholders are recorded as loans, consider having the company provide security for the debt. If the company gets into financial difficulty, the shareholders could potentially be paid back before unsecured creditors. Talk to us about whether this is possible for your situation.

• Have a dividend and drawings policy. Instead of taking funds out of the business as drawings or dividends unchecked, establish a regular amount that you stick to. This amount can be worked out at the start of each year when you do your budget and forecast to ensure you don’t strip the company of much-needed cash.

• Keep shareholder loan balances in proportion to shareholding. If you have a 25% shareholder and a 75% shareholder, establish what the company can afford to pay out to shareholders each month, then distribute it 75:25 to shareholders. E.g. if monthly drawings total $10,000, the 75% shareholder gets $7,500 and the 25% shareholder gets $2,500. This ensures no shareholder ends up funding more than their proportionate share of the company. Get in touch if you have multiple shareholders and need support ensuring your Shareholder Current Accounts stay in proportion to shareholding.

• Pay working shareholders a wage. Paying a market wage to shareholders does two things: it allows the company to realistically measure profit (as the true wage cost is included in the expenses) and makes tax planning easier (as tax can be paid out each month as opposed to getting lumpy tax bills). Talk to us about the benefits of paying yourself a wage vs taking drawings from your company.

If you’d like to learn more about your financial reports, the key financial ratios you should be measuring, and how to improve your results, get in touch to find out how we can help.

Book a call HERE and we will help you!

Mick

I’d love to help you achieve your business dreams, please don’t hesitate to contact me;
07 5646 4050
mick@ignitionaccountants.com