Why the Balance Sheet is so Important to the Business
Listen to an executive that knows their business and they will tell you about the health of the business’s Balance Sheet, because they know that it is the Balance Sheet that will make or break their business (literally).
Why is the Balance Sheet so important? The Balance Sheet shows executives, lenders and investors about the true financial health of the business! Simply stated, in accounting terms, if assets are less than liabilities the business is in trouble financially.
So why do so many executives never talk about their business’s Balance Sheet? For one, the Balance Sheet is boring to talk about versus sales which are exciting to talk about. Remember that countless businesses have grown themselves right out of business, due to the fact, that while the business was focused on growing, no one was paying attention to the Balance Sheet. Examples include: Accounts receivables ballooning, inventory levels are sky high, accounts payable are out of control and the business took on a bunch of debt. In the meantime, there is no cash in the bank account, because no one was watching the Balance Sheet.
Below are a few Balance Sheet ratios that every executive needs to know and understand about their business:
- Quick Ratio (Acid Test) is a ratio that measures if a business has enough current assets, excluding inventory and prepaid(s) to cover its current liabilities (accounts payable, accrued payroll, lease payments) that need to be paid timely. A business needs to have a Quick Ratio > 1 to show liquidity.
- Days Sales Outstanding (DSO) is a working capital ratio that measures the average number of days that a business takes to collect a customer invoice (sales on credit into cash). A low DSO number shows that a business is collecting their accounts receivable timely, while a high DSO number shows that a business is taking a longer time to turn its accounts receivable (sales made on credit) into cash. Find out what is the average DSO for your industry as a benchmark
- Inventory Turnover is another working capital ratio that helps to measure the effectiveness of a business’s inventory management. Executives need to be aware of accounting methods used to value inventory. (i.e. drop shipments, LIFO, FIFO and the worst of all the FISH method – First In Still Here). Generally, the higher the inventory turnover number the better the inventory is being managed.
- Total Debt to Total Assets is a ratio that quantifies the percent of assets that vendors and lenders have claims for payment against the assets of a business. A privately held business should exclude notes receivable and payable to and from shareholders. The higher the Total Debt to Total Assets ratio, the worse a business’s liquidity.
Banks and investors will use these types of ratios to measure the business’s liquidity (ability to pay back debt) and management of the business’s operations. That this is why executives that manage financially healthy businesses know why their Balance Sheet is so important!