Strengthening Your Balance Sheet
Your balance sheet 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. Businesses with strong balance sheets are more likely to survive economic downturns and be ready to thrive when the economy starts to rise again.
A strong balance sheet goes beyond simply having more assets than liabilities. Entities with strong balance sheets are those which are structured to support the entity’s business goals and maximize financial performance.
Intelligent Working Capital
A strong balance sheet will utilize an optimal level of working capital (current assets less current liabilities) to fund the business’ core operations, with the end goal of driving revenue and subsequently profit. Having too many funds tied up in stock will strangle your cash flow and reduce your ability to meet financial obligation as they fall due.
Positive Cash Flow
Cash, also known as ‘business oxygen’, is the most evidential sign of a strong balance sheet. Your business cannot breathe without cash flow. All businesses need cash to achieve their short-term goals – to pay employees, trade payables and a lot of other expenses. It’s therefore vitally important to manage cash flow through forecasting and budgeting.
Cash is king. So chasing your customers who owe you money and getting this cash in your bank account while not altering your net asset position will mean you can disclose a healthy cash balance adding confidence to those reading your balance sheet.
Tests to take that quickly reveal your solvency
The Current Ratio Test
This is a simple test that involves dividing your assets by your liabilities. Both these figures come off the balance sheet.
Here is an example:
If your business has current assets of $692,000 and current liabilities of $227,000, the current ratio equals 692000 divided by 227,000, with the ratio equaling 3.05.
This means that for every dollar of debt, the business has $3.05 of assets. This means that the business is solvent. Most banks would regard $2 for every $1 of debt as acceptable for the minimum ratio.
But, hang on a second. Your inventory is included in your assets. What is your stock really worth? If you had to sell it all in the near future to be able to pay all your debts, would you be able to get the full amount that is shown on the balance sheet?
The Quick Ratio Test
This test is similar to the current ratio test but this time it is leaving out your inventory/stock. The aim of the ratio is to find out if your business has enough ready cash to pay your bills, if your creditors demanded payment tomorrow.
For example, let’s say the business has $515,000 in inventory. Subtract this number from the current assets figure of $692,000, therefore the inventory is reduced to $177,000. This make the Quick Ratio, $177,000 divided by $227,000 equals 0.78.
Now this does not look so good. The business only has 78 cents in ready cash for every dollar of debt. This means that the business could not pay off its debt immediately.
To be able to pay off your debt quickly, your aim should be to have at least $1 in assets available in quick cash for every $1 of debt, meaning there is a ratio of 1:1.
Tips on how to improve your balance sheet.
There are numerous reasons why a business might not have a strong balance sheet:
Poor financial performance,
Taking on unserviceable debt (debts you cannot afford)
Stripping too much money out of the business.
And the list goes on……
If you are an owner of a fragile balance sheet, then you should engage a business advisor to get to the root of the problem before it’s too late. A good advisor will do three things: identify the causes of the weak balance sheet, suggest processes and actions for improvements, and enforce accountability.
Improve inventory management.
If you trade in goods, review your inventory levels immediately. If stock is obsolete, then shift it out the door – the cost of holding onto it could be more than you realise.
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 to pay your debts, would you get the full amount shown on the balance sheet? In a great deal of businesses, the answer is no. You need to value your inventory/stock at market value, which is what you can realistically sell it for today. It is no point buying computers for resale at $2000 each in 2014, then valuing them at $2000 each in 2019 at cost price because they devalue very quickly.
Review your procurement strategy.
Do you have a purchasing schedule for the year, and is it being adhered to? Are you buying too late and missing out on seasonal sales? Make sure someone is responsible for this function of the business and plan, plan, and plan – a forward focus is crucial. Purchasing in bulk may be another cost saving rather than piece by piece, as long as it is not overstocking, and you are sure you can move the product quickly. This also may give you significant discounts.
Look at the collection of your receivables.
Are slow paying debtors slowly strangling your business? You might need to implement a more aggressive collection strategy to ensure you get paid on time.
Maintain a forward focus.
Always ask yourself, what’s around the corner? What are the threats to your current position? What strategic plans should you make for the future? Your balance sheet should reflect your business strategy.
Taking steps to strengthen and maintain a strong balance sheet will help your business thrive during even the toughest times. It also decreases the risk of failure
Growing a business can be expensive, a strong balance sheet will serve as a foundation from which you can launch into new products and markets. Not to mention, bankers love nothing more than seeing a solid balance sheet with healthy cash reserves and a balance capital structure when assessing loan applications.
Hills Accounting is an accounting firm that excels at servicing your accounting needs. Visit www.hillsaccounting.com.au or call 62737800 to start your journey with us.